Maximising value from your reinsurance spend

Transcription

1 Maximising value from your reinsurance spend Many companies are overlooking a new opportunity to improve the effectiveness of the reinsurance purchase process. But hidden redundancies can now be identified and value created. September 2011

2 PwC Maximising value from your reinsurance spend

3 PwC Maximising value from your reinsurance spend 1 Buying reinsurance is one of the biggest costs incurred by insurers yet many companies are overlooking a new opportunity to improve the effectiveness of the purchase process. PwC s 1 Bryan Joseph, James Quin and Donald Brignell look at how, with a small amount of refinement, leading insurers can use their Solvency II modelling to identify hidden redundancies in reinsurance spend. Gaining added value from reinsurance is very important to companies operating in the current climate. Soft direct markets, a shortage of capacity in the retro market, record claims activity, the demands of implementing Solvency II and unpredictable returns from extremely volatile investment markets amount to what feels like the perfect storm for underwriting companies. With pressure on profit margins, the price paid for reinsurance is coming under renewed scrutiny. For many small and medium sized companies, the cost of reinsurance is by some distance the most significant expense after staff and claims costs. CEOs who are looking to outperform the sector are now taking a long hard look at how preparations made in anticipation of Solvency II can also give them an extra weapon to improve the value of their reinsurance strategies. Leaking profit or gaining economic benefit? The average spend on reinsurance across the London market is approximately one quarter of gross written premium (GWP). Reinsurers set their profitability targets on working layer reinsurance treaties at upwards of 25% of the expected loss ratio. For higher layers, the profit targets are set significantly higher. As a result, the revenue accounts of most insurance companies have been significantly tilted in favour of their reinsurers. The effect is that, with margins increasingly squeezed, insurers are ceding profits worth at least 5-10% of their GWP in order to manage the volatility of the underwriting account. Without the right analytical tools in place, it is not clear that all of this sacrifice of profit is delivering any overall economic benefit. 1 PwC refers to the network of member firms of PricewaterhouseCoopers International Limited (PwCIL)

4 2 PwC Maximising value from your reinsurance spend Balanced against this, 2011 has already proven to be the costliest year on record in terms of economic losses arising from natural disasters. Munich Re estimates economic losses from the first six months of the year as a staggering US$265 billion, with the insurance industry bearing US$60 billion of those losses. 2 Over the medium term, both the incidence of natural disasters and the value of insured property are forecast to increase, exposing more and more wealth to the risk of catastrophic loss. Clearly, in such an environment, improving return on equity is not simply a matter of purchasing less reinsurance cover. Companies do, however, need to be sure that their reinsurance buying decisions are informed by effective modelling and analysis. The internal capital model that they have had to develop in time for the implementation of Solvency II gives them a state of the art reinsurance portfolio analysis tool. 2 Munich Re press release 12 July 2011 Getting better control of reinsurance purchasing activity Have companies got the right tool kit to support their reinsurance purchasing decisions or is it still a matter of identifying a good price by relying on instinct and experience? The answer is that in the majority of cases, the internal capital model that they have had to develop in time for the implementation of Solvency II gives them a state of the art reinsurance portfolio analysis tool. Considerable resources have been spent by insurers developing, refining and validating complicated models that calculate the economic capital requirements of their organisations. A by-product of this activity is that they have had to produce as detailed and accurate a view of gross portfolio risk exposure as could possibly exist. With some minor refinements, these tools can become an extremely powerful way of examining the individual benefits of every reinsurance contract purchased, and, more significantly, the impact of reinsurance on the portfolio as a whole. There are two main ways of looking at the benefits of reinsurance. The simplest is to consider the impact of each potential treaty in isolation. With very basic or no modification a capital model can forecast the expected level of recovery a company would get from a specific coverage in an average year. It will also be able to identify, for example, the probability of recovering at least as much as the cost on each individual coverage, enabling management to make an accurate judgment on whether the price seems fair for that particular layer and which reinsurance treaties are relatively good value. This is information that the broker and reinsurer may already be modelling and sharing with your organisation but it makes sense to have an internal view. It is particularly relevant for more working layer treaties where, as the direct insurer, the information and understanding a company has of its risks is far more comprehensive than that of the reinsurer or the broker. Using this basic approach, the view of whether a particular deal is good value or not is much less subjective. The additional information also means that the negotiating position of an insurer becomes far stronger on each individual coverage that it might buy. This approach, however, is only really scratching the surface of what the tool can do. Because the capital model can be used to model the complete reinsurance programme across the entire enterprise at the same time, the reports it can produce can consider the performance of the whole programme after the impact of

5 PwC Maximising value from your reinsurance spend 3 Figure 1: Using reinsurance heat maps Per risk 1xs1 3xs2 5xs5 10xs10 25xs20 Aviation Cargo Specie Hull High utilisation Medium utilisation No utilisation Reinsurance heat maps provide a simple graphical comparison of which treaties are working hardest and whether the programme as a whole is calibrated efficiently. In this simplified example, there are clear savings that could be made by restructuring the cargo and specie coverage. diversification. PwC has worked with insurers who have identified a huge difference in purchasing priority once this new intelligence has been taken into account. With this enterprise-wide view of the reinsurance programme, companies can estimate the actual amount of economic capital each individual coverage is saving and, in turn, its monetary and economic value to the business in terms of the actual cost of capital. Companies benefit from a straightforward technical way of determining whether a contract is creating or destroying value within the organisation at whatever price is quoted. An added benefit of this approach is that it helps to fulfil the EU requirement that Solvency II capital and risk models are not just theoretical constructs, but are actually used to direct and evaluate business decisions. Using a capital model in this way enables insurers to demonstrate a very real link between its output and actual business decisions and can be used as evidence that fulfils the EU use test. Delivering greater profitability Some insurers are coupling this type of analysis with more advanced analytics that enable them to fine-tune portfolio risk appetite. A simple example is using the ability to capture expected recoveries at different points of the gross loss distribution to see at what point the excess of loss reinsurance is coming into play and refining whether this makes sense in the context of the business s overall risk appetite. A further refinement is the creation of reinsurance heat maps (see Figure 1) These highlight graphically which contracts are working the hardest in the scenarios that lead to a capital strain. Companies can then reduce spend on those coverages whose impact is effectively being diversified away and concentrate their reinsurance spend

6 4 PwC Maximising value from your reinsurance spend where it has most impact on capital requirements and return on equity (RoE). The picture is completed with either real or virtual internal reinsurance arrangements. These enable individual underwriters to manage their book while retaining flexibility and negotiating strength over purchasing the best deals within a specialist central purchasing function. The benefits of this type of work are dependent on the original structure of reinsurance in place, but it is not uncommon for the companies we have worked with to be able to achieve a significant increase in net premiums with no or limited impact on capital requirements. They are gaining a material impact on combined ratio and target RoE. For example, one insurer upped its per risk and cat retention, reduced its writing of peak exposure and increased cold stop reinsurance. The impact on profitability was significant with little change in capital requirement, taking account of the results from the last five years as well as the results from future scenarios. At a time when investors have become ever more cynical about the diversified insurance business model and as to whether Solvency II will deliver any tangible benefits, this can only help CEOs and CFOs looking to differentiate their company and demonstrate value creation. Act now The gains from developing this type of modelling go straight to the bottom line. They improve individual reinsurance decisions and enable companies to get better centralised, across the board insight on the use and effectiveness of reinsurance spending as a whole. Many companies have already developed systems in anticipation of the Solvency II requirements that can easily be adapted to perform this task. By doing so, companies can begin to turn what, up to now, has been a regulatory cost into a monetary benefit. It is timely to talk to your capital modelling team about what they currently do and what more they could do in this area; what they think is possible; and what information management might ideally want to better manage the reinsurance buying process. If brokers provide this type of analysis for your organisation, ask if the information provided fits in with your needs and expectations or whether the company can do better by making effective use of its own resources. Are they justifying their fees by giving you what you need? By observation, the industry as a whole is getting smarter in this area, which means that companies that fail to address these questions now risk losing significant ground on their peers. One insurer upped its per risk and cat retention, reduced its writing of peak exposure and increased cold stop reinsurance. The impact on profitability was significant with little change in capital requirement, taking account of the results from the last five years as well as the results from future scenarios.

7 PwC Maximising value from your reinsurance spend 5 Giving you the edge If you d like to discuss any of the issues raised in this paper or know more about how your business can maximise value from its reinsurance spend, please contact one of the authors listed here: Bryan Joseph Global Actuarial leader, PwC (UK) +44 (0) bryan.rp.joseph@uk.pwc.com James Quin European Insurance Market Reporting leader, PwC (UK) +44 (0) james.b.quin@uk.pwc.com Donald Brignell Associate Director, PwC (UK) Direct: +44 (0) donald.brignell@uk.pwc.com

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