How To Manage Capital From A Reinsurance To A Catastrophe Risk

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1 REINSURANCE SOLUTIONS Managing Economic And Rating June 2009 redefining Capital Access Advocacy Innovation

2 Contents Capital 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 9 A.M. Best and S&P Capital Models 11 Economic Capital Model 11 Results of Capital Modeling 12 Reinsurance Purchasing Decision 16

3 AON BENFIELD 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. 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. 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. 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. 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 3

4 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL 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 A.M. Best S&P Reducing retentions to EUR10mn per risk 6.2% 8.6% 19.9% 21.3% EUR2bn ADC attaching at EUR1bn below carried reserves 13.3% 6.3% 9.6% 11.9% EUR1bn ADC attaching at carried reserves 12.5% 11.0% 11.5% 14.4% EUR1bn ADC attaching above carried reserves 10.8% 5.6% 2.8% n.m. 20% quota share 20.0% 11.0% 35.1% 23.6% EUR1bn additional catastrophe covers 4.5% 8.3% n.m. 5.6% EUR1bn debt reduction with 20% quota share 20.0% 11.0% 86.0% 107.6% The reinsurance options 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. 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. 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. A second event catastrophe cover will provide capital relief in A.M. 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 A.M. 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 4

5 AON BENFIELD companies, as the cedent is transferring both premiums and future reserves, which reduce overall capital requirements. When determining which reinsurance solutions will optimize capital adequacy, it is important to understand which risk factors are driving capital requirements, and then tailor the reinsurance to respond accordingly. The following section discusses the reinsurance programs highlighted in Table I. Reducing Per Risk Retentions Many insurers have sharply increased per risk retentions for standard and specialty lines of business. Retentions for lines such as general liability, commercial motor, workers compensation and directors and officers liability have increased from a range of EUR1mn to EUR5mn in the mid 1990s to EUR10mn to EUR25mn by These higher retentions have greatly increased exposure to the underwriting cycle and adverse reserve development risk of most commercial insurers. CFOs in many cases are studying the potential benefits of reducing per risk retentions in addition to considering adverse development covers to help manage capital. Reserve Covers A significant portion of the risks that insurers face relate to loss reserves. Many CFOs are evaluating the potential benefits of reserve covers attaching within the reserves, above the reserves, or after a significant loss reserve corridor. These covers provide varying levels of enterprise risk, reserve and capital relief. This relief can be structured to match the capital needed to replenish balance sheet strength that has been reduced by investment related issues. Quota Share Premiums, as a measure of underwriting risk, attract significant economic and rating agency capital. Quota share reinsurance provides premium relief through cessions to the reinsurers. It also has the added benefit of providing the flexibility to finance growth when there are market opportunities, or to help insurers maintain their franchises while faced with reduced capital bases. Catastrophe Cover CFOs recognize that the most accretive way to manage peak catastrophe risks is through catastrophe reinsurance. However, many insurers have relied materially upon an economic capital cushion to finance growth opportunities or to sustain higher net catastrophe risks. In such cases, insurers may have purchased only to the 75 or 100 year return period events when their economic and rating agency capital models stress capital to 250 year events or beyond. In these cases, CFOs have been able to gain additional capital management leverage through increasing catastrophe reinsurance limits. 5

6 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL Earnings Volatility Management Effective use of reinsurance can help a company manage its earnings volatility and also reduce capital requirements, generally at terms accretive to capital. Using A.M. Best US property and casualty commercial lines data, the accident year gross loss ratio over the past 10 years is with a standard deviation of 12.47, while the accident year net loss ratio is with a standard deviation of Therefore, reinsurance reduced the standard deviation by 2.60 loss ratio points, or percent. The sector can be characterized as having reasonable long-term returns, but volatility that is well above the averages of many other sectors. Chart 1 shows the quarterly volatility of earnings per share data for the commercial lines sector. While 2008 is colored by the misfortunes of AIG, the impact of 9/11 and the hurricane losses of 2005 are clear to see. Chart 1 Commercial Lines Sector Earnings Volatility Quarterly EPS/BV Earnings Per Share Commercial Lines Sector Q1 00 Q1 01 Q1 02 Q1 03 Q1 04 Q1 05 Q1 06 Q1 07 Q1 08 Source: BASELINE, Bloomberg, First Call, Company Data, Aon Benfield Analytics CFOs routinely review the value of reducing earnings volatility through changes in the limits underwritten at various times within any cycle and how much of those limits should be reinsured. On a quarterly basis, Aon Benfield publishes the financial results as part of an insurer volatility study. This empirical data assists CFOs in benchmarking results and progress. The scope of this study is extensive and covers the majority of all public insurers and reinsurers for a period of more than 10 years. The ranking of commercial insurers from the most recent quarterly study is presented in Table 2. The commercial sector is significantly more volatile than the overall insurance industry. The earnings per share (EPS) coefficient of variation (CV) for the commercial sector is 195 percent, compared to the combined insurance industry s CV of 114 percent. The S&P 100 s CV is 26 percent. 6

7 AON BENFIELD Table 2 Cumulative Earnings Volatility Rank Low High I Year 3 Year 5 Year 7 Year Harleysville Group Inc Ace Limited Cincinnati Financial Corporation Cincinnati Financial Corporation Tower Group Inc Harleysville Group Inc The Chubb Corporation The Chubb Corporation Ace Limited The Chubb Corporation Harleysville Group Inc The Travelers Companies Inc Mitsui Sumitomo Insurance Company Ltd The Travelers Companies Inc The Travelers Companies Inc Ace Limited Cincinnati Financial Corporation Cincinnati Financial Corporation Zurich Financial Services AG Mitsui Sumitomo Insurance Company Ltd The Chubb Corporation Tower Group Inc Sompo Japan Insurance Company Ltd Old Republic International Corporation The Travelers Companies Inc Zurich Financial Services AG Ace Limited Harleysville Group Inc Tokio Marine Holdings Inc Mitsui Sumitomo Insurance Company Ltd Mitsui Sumitomo Insurance Company Ltd Old Republic International Corporation CNA Financial Corporation The Hartford Financial Services Group Inc The Hartford Financial Services Group Inc Sompo Japan Insurance Company Ltd XL Capital Ltd Sompo Japan Insurance Company Ltd Tokio Marine Holdings Inc Allianz SE Sompo Japan Insurance Company Ltd XL Capital Ltd CNA Financial Corporation Fairfax Financial Holdings Zurich Financial Services AG Tokio Marine Holdings Inc Old Republic International Corporation XL Capital Ltd Fairfax Financial Holdings The Hartford Financial Services Group Allianz SE CNA Financial Corporation Inc CNA Financial Corporation Fairfax Financial Holdings Fairfax Financial Holdings American International Group Inc American International Group Inc Allianz SE XL Capital Ltd The Hartford Financial Services Group Inc Allianz SE Old Republic International Corporation American International Group Inc Source: BASELINE, Bloomberg, First Call, Company Data, Aon Benfield Analytics American International Group Inc Conclusion For most lines of business, reinsurance is currently the single form of capital that remains available at accretive terms to the insurance sector. While there has been some favorable movement recently, debt and equity capital remains in very limited supply and at a cost far greater than historical averages and that of reinsurance alternatives. Restoration of the debt and equity markets to full functionality will take time, as the broad market continues to be plagued by employment, housing and other systemic issues. With continued disruption in the debt and equity markets, it is more critical than ever for insurers to evaluate fully the characteristics of their capital structure and optimize the use of reinsurance as a key component. The cost of reinsurance relative to the reduction in risk provided by various reinsurance structures should be considered through rating agency, regulatory and internal economic capital models, enabling cost of capital comparisons. There are numerous reinsurance products available, and it is important to understand the underlying risks of the company to identify the appropriate reinsurance product to transfer the optimal risk to the reinsurer at a reasonable cost. Aon Benfield is uniquely positioned to evaluate the characteristics of all forms of available capital, accessing the most efficient and effective capital solutions to achieve corporate goals. 7

8 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL Analysis 8

9 AON BENFIELD Analysis Economic Capital, A.M. Best and S&P use different approaches to calculate capital requirements and benefits and this explains the variation in ceded ROE, or cost of reinsurance capital, A CFO is likely to look at capital in various ways: from an economic perspective, possibly based on an internal economic capital model, as well as rating agency capital, as generally this is the capital constraint for the company. This analysis will provide insight into the various approaches to enable better understanding of the mechanics of the proposed reinsurance structures and their impact on capital requirements. Discussion of Analysis Aon Benfield created a hypothetical European company as the basis for this analysis, with the following parameters: EUR10bn of capital EUR15bn of net premiums written EUR25bn of reserves. Reserves are a mix of property and casualty, with 75 percent of the reserves in long-tail casualty lines, with a payout that extends more than 20 years. The 1 in 100 occurrence net post-tax PML for European wind is 3 percent of capital, and the 1 in 250 all peril aggregate net post-tax PML, again for European wind, is 11 percent of capital Investment portfolio: 75 percent bonds (94 percent of which are rated A or higher), 16 percent equities, 5 percent cash and 4 percent other The invested asset to surplus leverage ratio is 3.8 These parameters are for illustrative purposes; they are not intended to indicate available capacity at the suggested cost. Actual pricing and limits will be company specific, and can be obtained by working with your Aon Benfield broker. The following section outlines the reinsurance options evaluated as summarized in Table 1. Proposed Reinsurance Solutions Reducing net retentions from EUR25mn to EUR10mn per risk A company looking to reduce earnings volatility could reduce its maximum net retention on any single loss from EUR25mn to EUR10mn. For the hypothetical company, the main exposure excess of EUR10mn comes from directors and officers liability, commercial property, and workers compensation. Adverse Development Covers ADCs have a one-time up-front cost but continue to provide benefit until the current reserves run off. Therefore, for a company with significant long-tailed reserves, the ADC will provide meaningful capital credit for several years after the initial purchase assuming reserve run off occurs as expected. The duration of the benefit will be specific to the company s payment patterns. 9

10 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL ADCs and loss portfolio transfers (LPTs) are considered retroactive reinsurance, and as such there are unique accounting requirements associated with these forms of reinsurance. The accounting can be onerous, so it is important to understand the local accounting requirements for retroactive reinsurance. EUR2bn whole account ADC that attaches EUR1bn below carried reserves In this scenario, the first EUR1bn ceded is essentially an LPT, and the second EUR1bn is an ADC. As the LPT will be on the reserves that are the last to pay, the discount covers much of the cost; however, this will depend on the company s specific reserve durations. Also, there is the possibility that the reserves are adequate or redundant, in which case the reinsurer keeps the excess. EUR1bn whole account ADC that attaches at carried reserves EUR1bn whole account ADC that attaches above carried reserves (above the estimated reserve deficiency) 20 percent whole account quota share (QS) A 20 percent quota share is assumed across all lines of business. For the hypothetical company writing at a 70 percent loss ratio, and a 10 percent required margin for the reinsurer, the ceding commission and profit commission will be 20 percent combined. Therefore, the annual cost is estimated to be the 10 percent reinsurer margin, net of tax. EUR1bn of additional catastrophe cover to exhaust at the 250 year occurrence event This assumes that the company was previously only buying to the 100 year event. Repaying EUR1bn of holding company debt with dividends from insurance subsidiaries and replacing capital with a 20 percent quota share Given the current debt markets, companies with debt maturing may be unable to replace the debt at similar terms. Therefore, companies that have downstreamed debt to operating subsidiaries for capital purposes could encounter a scenario where the operating company would have to transfer capital back to the parent company as dividends to repay the debt, with no ability to replace it. The operating company then has EUR1bn less of capital, with no change in exposures, which would likely have a significant adverse impact on capital adequacy. Reinsurance can replace this lost equity at the operating entity level. This paper assumes that the company would upstream EUR1bn of capital, as a dividend to its parent, and replace that capital with a 20 percent QS. 10

11 AON BENFIELD A.M. Best and S&P Capital Models The starting Best s Capital Adequacy Ratio (BCAR) for the company is 168 percent. This assumes that an A rated carrier strives to hold at least 15 BCAR points, or one rating notch, of capital cushion above the minimum for the rating (145 percent for an A rated company). The initial S&P enhanced capital model for the company shows a relatively small diversified capital deficiency at the A rating level of approximately EUR50mn (equivalent to less than 1 percent of total adjusted capital). Detailed discussions of each of the scenarios and the impact on the A.M. Best and S&P capital requirements are explained in the following section, which includes a Capital Management Transactions summary for each scenario. Economic Capital Model Currently, there is no definitive calculation for economic capital. Many companies are developing internal dynamic financial analysis models to help assess required levels of capital for regulatory, rating agency and internal management purposes. Regulators and rating agencies will generally only give credit for such models if they are clearly used in all aspects of decision making within the company. In order to provide an alternative view, an economic capital methodology based upon the principles underlying the proposed European Solvency II regulations is included. A stochastic model of the company s income and balance sheet over a one year time horizon has been developed. The capital benefit of each reinsurance option is based upon the reduction in volatility for the portfolio. Because of the predominance of casualty business for the hypothetical company, the selected economic capital methodology will place more weight upon structures that reduce the impact of adverse casualty results. Companies with more catastrophe risk relative to the capital base would see more economic capital benefit from the catastrophe cover than that shown in Table 1. Aon Benfield s ReMetrica model is used by over 100 insurers and reinsurers to calculate their internal capital requirements. 11

12 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL Results of Capital Modeling Option 1: Reducing Retentions from EUR25mn to EUR10mn Per Risk The company would cede approximately EUR59mn of net after-tax underwriting profit, on EUR480mn of ceded premiums. The resulting A.M. Best capital benefit is EUR298mn of equivalent capital at a 19.9 percent relative cost of capital. The equivalent S&P capital benefit is EUR278mn of equivalent capital at a 21.3 percent relative cost of capital. Option 1 Reducing Retentions to EUR10mn Per Risk Underwriting Volatility Ceded EURmn Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 6.2% % % % Option 2: EUR2bn Adverse Development Cover (ADC) that Attaches EUR1bn Below Carried Reserves The company would cede EUR1bn of reserves and cash with no impact on surplus. The embedded discount in the last EUR1bn is approximately 40 percent or EUR400mn, which is the true cost as the company is ceding this to the reinsurer. However, as an LPT does not transfer any risk or volatility to the reinsurer, there is no benefit in either the A.M. Best or S&P capital models for the first EUR1bn. The EUR1bn of ADC provides EUR565mn of capital in the BCAR over the life of the cover, at an overall 9.6 percent cost of capital. The same ADC provides EUR457mn of capital in the S&P model, at an overall cost of capital of 11.9 percent. The mechanics of the ADC are noted in the next option. Option 2 EUR2bn ADC Attaching at EUR1bn Below Carried Reserves Underwriting Volatility Ceded EURmn Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 13.3% % % % Option 3: EUR1bn ADC that Attaches at Carried Reserves The limit is first applied to the deficiency as this would be first ceded to the ADC. It is assumed that the company has EUR660mn of reserve deficiency, which leaves EUR340mn remaining to reduce reserve requirements. In the BCAR model the credit for the ceded deficiency is adjusted through the loss reserve equity, which is in the other adjustments to surplus. The remaining limit is a reduction to B5 Loss and LAE required capital. Given the mechanics of the BCAR and the covariance adjustment, for a reserve driven company, it is more beneficial to reduce capital requirements than to increase available capital. S&P is not as transparent in calculating the capital benefit of an LPT or an ADC as A.M. Best. S&P will be releasing a report on the capital benefit calculation for the Berkshire ADC provided to Swiss Re. This can likely be extrapolated to the various ADC scenarios presented in this paper. Aon Benfield assumes that the reserve deficiency would first be ceded to the ADC, which in the S&P model would result in an addition to total adjusted capital, and the discount on the remaining limit would be a reduction from C4 Reserve Risk. 12

13 AON BENFIELD The estimated rate on line (ROL) is 45 percent, which results in an after-tax cost of EUR292mn. By comparison the ADC results in EUR532mn of capital provided in the BCAR over the life of the cover, at a relative cost of capital of 11.5 percent. In the S&P capital model EUR424mn of capital is provided in the BCAR at a 14.4 percent cost of capital. Option 3 EUR1bn ADC Attaching at Carried Reserves Underwriting Volatility Ceded EURmn Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 12.5% % % % Option 4: EUR1bn ADC that Attaches Above Carried Reserves (Above Estimated Reserve Deficiency) The estimated ROL is 28 percent, which results in an after-tax cost of EUR179mn. The lower ROL results from the reduced likelihood of a company ceding actual losses to the ADC as this attaches above carried reserves, where the previous option attached at carried reserves. Since this ADC is attaching above the estimated deficiency, the full limit is applied to B5 net loss and LAE reserves risk in the BCAR. This assumes that the ADC is entirely within the risk layer. As previously discussed, given the mechanics of the BCAR, for the hypothetical company it is more beneficial to reduce capital requirements than increase capital. Since the full limit reduces capital requirements, the capital provided is ultimately a multiple of the limit, as the overall capital requirements are now optimized. This ADC results in EUR1.4bn of capital provided in the BCAR over the life of the cover, at a relative cost of capital of 2.8 percent. In the S&P model, C4 Reserve Risk is reduced by the discount on the full limit. Due to S&P s differing treatment, this provides only EUR12.5mn of capital at a 93.6 percent cost of capital. It should be noted that a substantial increase in capital adequacy subsequent to an ADC is not likely to result in an upgrade of a company; nor can an ADC be used to replace hard capital a company might want to transfer as dividends to a parent or affiliate. An ADC can provide immediate capital relief when a company is facing a negative outlook or downgrade due to capital adequacy that does not support the current rating, or the company has experienced significant adverse reserve development and reserve volatility. This relief might help prevent a change in outlook or downgrade when coupled with a strategy to correct the underlying issues that contributed to the company s decline in balance sheet strength. Option 4 EUR1bn ADC Attaching Above Carried Reserves Underwriting Volatility Ceded Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 10.8% % 1, % 13 n.m. EURmn n.m. = not meaningful Option 5: 20 Percent Whole Account Quota Share (QS) Given that the ceding commission is paid based on written premiums, though ceded profit is based on earned premiums, the first year of a QS generally increases the surplus. This is due to the fact that premiums will be written throughout the year, so only 50 percent will be earned at the end of the year, while 100 percent of the ceding commission is paid. A QS would need to be purchased annually to continue to receive this credit in the A.M. Best and S&P capital models in future years. 13

14 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL In the first year of a 20 percent QS, there is EUR859mn of capital provided in the BCAR, at an estimated cost of capital of 35.1 percent. The capital provided in the S&P model is EUR1.3bn, at an estimated cost of capital of 23.6 percent. In the second year of the QS, the capital provided in the A.M. Best model would be EUR540mn at an estimated cost of capital of 55.9 percent. The S&P model would provide EUR945mn of additional capital at an estimated cost of capital of 31.9 percent in this period. As this is a long-tailed casualty company, over time as the reserves build up, the company will see more benefit to the QS in each of the capital models. Option 5 20% Quota Share Underwriting Volatility Ceded Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 20.0% 2, % % 1, % EURmn Option 6: EUR1bn of Additional Catastrophe Cover to Exhaust at the 250 Year Occurrence Event, Assuming that the Company was Previously Only Buying to the 100 Year Event The estimated ROL for this option is 3.5 percent, which results in an after-tax cost of EUR23mn. The company is already buying nearly up to its 1 in 100 event (European wind being the peak peril with no US exposure). Since A.M. Best does not give quantitative capital credit for reinsurance above the peak peril, there is little capital credit in the BCAR for this scenario. The EUR1bn of additional catastrophe cover provides EUR10mn of equivalent capital in the A.M. Best model compared to a cost of EUR23mn. However, there could be qualitative capital credit from a risk management perspective as the company is buying reinsurance above their modeled loss to compensate for model miss or unmodeled risks. This is true particularly for companies with significant historical volatility from catastrophes, companies with actual historic catastrophe losses in excess of the modeled loss, and companies with poor data quality. S&P includes a 1 in 250 aggregate all peril PML estimate in its Enhanced Capital Model. Consequently, as the additional EUR1bn of catastrophe reinsurance attaches above the 1 in 100 occurrence based PML, there is substantial quantitative credit for this under S&P whereas there is not any credit in the BCAR. There is EUR636mn of capital provided overall at a relative cost of capital of 5.6 percent. Economic capital models will also tend to give considerable credit for catastrophe reinsurance purchased in excess of 1 in 100 or even 1 in 250 event limits. For a highly catastrophe exposed company the optimal reinsurance for a modeled economic capital perspective is often to buy the maximum amount of cover as high as possible before minimum market rates on line begin to apply. When compared with the S&P rating agency capital, the economic capital benefit is low in this scenario as the casualty reserves are a significant driver of the required capital. 14

15 AON BENFIELD Option 6 EUR1bn Additional Catastrophe Covers Underwriting Volatility Ceded EURmn Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 4.5% % 10 n.m % Option 7: Repaying EUR1bn of Holding Company Debt with Dividends from Insurance Subsidiaries and Replacing Capital with a 20 Percent Quota Share (QS) The QS entirely replaces the EUR1bn of capital paid to the parent to pay off the debt, and provides an additional EUR351mn of capital in the BCAR and EUR280mn in the S&P capital model. In each model the combined cost of capital reflects the cost of the QS and the decline in capital. However, the proper analysis would be to compare the cost of debt (if the company could obtain debt) to the cost of the QS, which is 35.1 percent in the BCAR and 23.6 percent in the S&P capital model. Option 7 EUR1bn Debt Reduction With 20% Quota Share Underwriting Volatility Ceded EURmn Economic Capital Benefit Economic Capital A.M Best Rating A.M. Best S&P Rating S&P Ceded ROE 20.0% 1, % % % 15

16 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL Reinsurance Purchasing Decision Companies should always discuss their planned reinsurance and capital strategies with their rating analyst prior to implementation so that the impact can be fully assessed. Companies also need to consider the impact of risk limiting features such as sub-limits, caps in the QS, corridors, sliding scale commissions and incentives for early commutation (which question the permanence of protection). These will all limit the benefit of reinsurance in the A.M. Best and S&P capital models. It is also important to consider the increase in the credit risk and reinsurance dependency in the models. These may be particularly harmful in a catastrophe stressed BCAR. As already noted a substantial increase in capital adequacy due to a reinsurance solution which reduces balance sheet risk is not likely to result in a ratings upgrade of a company. In tandem with an appropriate underlying strategy it may, however, provide immediate capital relief that might help prevent a downward revision in outlook or a rating downgrade. The BCAR model and the S&P capital model for the baseline scenario and the various scenarios discussed above are shown in Tables 3 and 4. Table 3 A.M. Best Best Capital Adequacy Ratio (BCAR) Estimated Capital Adequacy Ratios Baseline Reducing Retentions EUR2bn - Attaching EUR1bn Below Carried ADC Attaching At Carried Above Carried 20% QS Cat Cover EUR1bn Div + 20% QS B1 Fixed income securities risk B2 Equity securities risk 2,226 2,226 2,226 2,226 2,226 2,226 2,226 2,226 B3 Interest rate risk B4 Credit risk 2,033 2,085 2,079 2,079 2,033 2,084 2,033 2,084 B5 Net loss and LAE reserves risk 5,808 5,584 5,471 5,471 4,808 5,646 5,808 5,646 B6 Net premium written risk 3,465 3,356 3,465 3,465 3,465 2,772 3,459 2,772 B7 Business risk Unadjusted capital 14,168 13,886 13,876 13,876 13,167 13,364 14,162 13,361 Covariance adjustment 6,069 5,998 6,039 6,039 5,897 5,655 6,066 5,651 Net required capital 8,099 7,887 7,837 7,837 7,270 7,710 8,096 7,710 Reported surplus 10,000 10,000 10,000 9,708 9,821 10,151 10,000 9,151 Catastrophe stress event (294) (294) (294) (294) (294) (229) (289) (229) Other adjustments 3,896 3,831 4,003 4,263 3,896 3,843 3,896 3,843 Adjusted Surplus (APHS) 13,602 13,537 13,709 13,677 13,423 13,766 13,607 12,766 Capital Adequacy Ratio 167.9% 171.6% 174.9% 174.5% 184.6% 178.6% 168.1% 165.6% Capital provided , Cost of capital 19.9% 9.6% 11.5% 2.8% 35.1% n.m. 86.0% n.m. = not meaningful EURmn 16

17 AON BENFIELD Table 4 Standard & Poor s Enhanced Capital Model Projected Redundancy / (Deficiency) 2008 Estimates at the 'A' Level ADC Attaching Baseline Reducing Retentions EUR2bn - Attaching EUR1bn Below Carried At Carried Above Carried 20% QS Cat Cover EUR1bn Div + 20% QS Total adjusted capital (TAC) 13,370 13,370 13,773 13,741 13,188 13,521 13,370 12,521 Target capital: C1 Asset risk 3,073 3,072 3,072 3,072 3,072 3,073 3,072 3,072 C2 Credit risk C3 Net premium risk 4,217 4,073 4,217 4,217 4,217 3,355 4,208 3,355 C4 Net reserve risk 4,907 4,758 4,841 4,841 4,712 4,770 4,907 4,770 C5 Operational risk C5 Property catastrophe risk 1,141 1,141 1,141 1,141 1, Total required capital - pre diversification 14,084 13,805 14,031 14,031 13,890 12,949 13,448 12,948 Diversification benefit Total net target capital 13,420 13,142 13,366 13,366 13,226 12,291 12,784 12,290 EURmn Diversified redundancy/(deficiency) (50) (37) 1, Capital provided , Cost of capital 21.3% 11.9% 14.4% 93.6% 23.6% 5.6% 107.6% 17

18 REINSURANCE SOLUTIONS: MANAGING ECONOMIC AND RATING AGENCY CAPITAL Contacts Should you have questions about this report, please do not hesitate to contact a member of the Aon Benfield Analytics team, including: Simon Martin simon.martin@aonbenfield.com Kelly Superczynski kelly.superczynski@aonbenfield.com Will Gerritsen will.gerritsen@aonbenfield.com 18

19 About Aon Benfield As the industry leader in treaty, facultative and capital markets, Aon Benfield is redefining the role of the reinsurance intermediary and capital advisor. Through our unmatched talent and industry-leading proprietary tools and products, we help our clients to redefine themselves and their success. Aon Benfield offers unbiased capital advice and customized access to more reinsurance and capital markets than anyone else. As a trusted advocate, we provide local reach to the world s markets, an unparalleled investment in innovative analytics, including catastrophe management, actuarial, and rating agency advisory, and the right professionals to advise clients in making the optimal capital choice for their business. With an international network of more than 4,000 professionals in 50 countries, our worldwide client base is able to access the broadest portfolio of integrated capital solutions and services. Learn more at aonbenfield.com. Aon Limited trading as Aon Benfield (for itself and on behalf of each subsidiary company of Aon Corporation) ( Aon Benfield ) reserves all rights to the content of this report ( Report ). This Report is for distribution to Aon Benfield and the organisation to which it was originally delivered only. Copies may be made by that organisation for its own internal purposes but this Report may not be distributed in whole or in part to any third party without both (i) the prior written consent of Aon Benfield. and (ii) the third party having first signed a recipient of report letter in a form acceptable to Aon Benfield. Aon Benfield cannot accept any liability to any third party to whom this Report is disclosed, whether disclosed in compliance with the preceding sentence of otherwise. To the extent this Report expresses any recommendation or assessment on any aspect of risk, the recipient acknowledges that any such recommendation or assessment is an expression of Aon Benfields opinion only, and is not a statement of fact. Any decision to rely on any such recommendation or assessment of risk is entirely the responsibility of the recipient. Aon Benfield will not in any event be responsible for any losses that may be incurred by any party as a result of any reliance placed on any such opinion. The recipient acknowledges that this Report does not replace the need for the recipient to undertake its own assessment. The recipient acknowledges that in preparing this Report Aon Benfield may have based analysis on data provided by the recipient and/or from third party sources. This data may have been subjected to mathematical and/or empirical analysis and modelling. Aon Benfield has not verified, and accepts no responsibility for, the accuracy or completeness of any such data. In addition, the recipient acknowledges that any form of mathematical and/or empirical analysis and modelling (including that used in the preparation of this Report) may produce results which differ from actual events or losses. The Aon Benfield analysis has been undertaken from the perspective of a reinsurance broker. Consequently this Report does not constitute an opinion of reserving levels or accounting treatment. This Report does not constitute any form of legal, accounting, taxation, regulatory or actuarial advice.

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