Non-traditional solutions for
Liability Exposures
Stuart Shepley
Chief Operating Officer
Ace Tempest Re (Europe)
Themes
• Will non-traditional business grow significantly?
• Is there ‘real’ value in buying a non-traditional deal?
• Should actuaries be underwriters?
Contents
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Introduction to non-traditional solutions
Products available
The current marketplace
Choosing a product and provider
Checklist
Introduction to non-traditional
solutions
Spectrum of products
Risk
financing
Financial
Reinsurance
Alternative
Risk
Transfer
Products
Risk
transfer
Traditional
reinsurance
Reinsurers
Equity &
Debt
Contingent
capital
Securitisation
Futures
Options
Capital
Market
Key characteristics of traditional R/I
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Single year deals
Guaranteed cost for single year with full risk transfer, however ….
Highly volatile renewal pricing
In hard market may not even be capacity available
Likely to be demand for payback following a loss
Limited profit sharing (although may be able to use “bank” in
negotiations)
• Generic “off the shelf” products
Key characteristics of ART
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Emphasis on financing as well as transferring risk
Risk spread over time and possibly product lines
Risk shared between insurer and reinsurer
Low finite limits
Premiums adjusted according to own experience
Concepts such as “payback” and “bank” as well as effect of investment
income made explicit
• Solutions tailored to specific client issues
ART
• So called alternative products concentrate on the most basic aims of
reinsurance
• …. as a risk management partnership between insurer and reinsurer
• … as an efficient form of capital for the insurance industry
• …. as a driver of shareholder value
• …. as a solution to specific industry issues (shortage of traditional
capacity, uninsurable risks, asbestos and environmental reserve
increases)
Needs met by ART
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Smoothing of fluctuations in reserve levels, catastrophic or large losses
Smoothing of reinsurance prices
Optimisation of balance sheet structure
Protection of security rating
Facilitation of mergers and acquisitions
Additional underwriting capacity precisely when it is required
Products available
Main Types of cover
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Loss portfolio transfer (LPT)
Adverse development cover (ADC)
Spread loss
Finite quota share (FQS)
Multi-year, multi-line products (MMP)
Multi-trigger products
Options to buy cover/multi-year deals
LPT/ADC
• Basic idea is to transfer outstanding claims reserves to reinsurer
• Reinsurer agrees to pay claims from a retention level (lower than
existing reserves) up to a pre-set limit (at or a little above existing
reserves)
• Reinsurer assesses likely pay-out of claims and charges premium equal
to discounted value of expected payment
• Adverse development cover protects against deterioration of claim
levels beyond current levels
• Reinsurer takes timing and investment risk and may take reserving risk
• Often crucial element of M&As or of putting lines of business into
run-off
• Particularly suitable for liability portfolios due to long settlement
periods and scope for volatile reserve development
LPT/ADC - Example
Balance sheet (before)
Reserves $75M
Current
Investment
income
$20M
Best
Estimate
Best
Reserves
Estimate
$75M
Discounted
Reserves
$55M
Deterioration cover
Limit
+$25M
Decrease in reserves
Premium
$60M
Balance sheet (after)
Reserves
$0M
Premium ceded
$60M
Improvement
$15M
Spread loss treaties
• Cover prospective claims
• In simplest form, an excess of loss type contract but for a multi-year
term and with the concepts of bank and payback made explicit within
the contract
• A single limit applies over the period of the contract
• An experience account is used to track the results of the contract
• Adjustable and return premiums used to adjust balance towards zero
• Party cancelling contract while “ahead” pays profit commission (if
reinsurer) or cancellation premium (if insured)
Experience Account
Balance bought forward
(5,000,000)
In quarter
Basic reinsurance premium
(Reinsurers' margin)
Additional reinsurance premium
15% of basic
25% of balance b/f
Claims paid
Notional interest on balance b/f
Balance carried forward
1,250,000
(187,500)
1,250,000
500,000
5% of balance b/f
(250,000)
(2,437,500)
Financial quota share
• Quota share with high profit commission, sliding scale ceding
commission and loss-caps
• May be multi-year deals with terms for subsequent years adjusted by
experience of earlier years
• Main aim is to increase underwriting capacity of insurer while
allowing them to retaining more of profitability of underlying business
than with conventional quota share
• One variation is an anti-cyclical quota share – ceding commission
increases as loss ratios increases, result is to smooth results of cedant
Coverage
Multi-year multi-line products
Year 3
Years
1-3
Year 2
Year 1
Traditional single line approach
• Yearly renewals
• Separate lines
• Large number of reinsurers
• Risk transfer
All lines
Integrated approach
• Multi-year
• Multi-line (including financial or
non-insurable risks)
• One provider
• Funded concept – spread loss
mechanism
Multi-trigger products
• Claims are paid only if, in addition to a conventional insurance event
(the first “trigger”) a pre-defined non-correlated event has also
occurred (the second “trigger”)
• More efficient cover as paid only when required
• E.g Catastrophe cover that is only paid if the FTSE has fallen in the
calendar year
• E.g. A bottom layer casualty excess of loss which only comes into
force if there has been a PCS natural event of pre-agreed magnitude
Multi-trigger products
Catastrophic
Loss
(Insurance
Event)
Multi
Trigger
Responds
Stock
Market Fall
(Financial
Event)
The current market
US P&C Industry Combined Ratio
120
115
110
105
100
Source: AM Best, 2002 estimate
02**
00
98
96
94
92
90
88
86
84
82
80
78
76
74
72
70
95
Insurers balance sheets hit
TOXIC MOLD
LADDERING
STX FALLS
Current convergence market
Our own industry
Current issues – ART products
• "(The FSA) has been investigating financial reinsurance with some
care and I have to say that we have found some more examples of
arrangements where it is wholly unclear whether any risk has in fact
been transferred and where the motivation seems purely
presentational” Howard Davies post Equitable Life failure
• FSA and Bank of England concerned at insurance of credit risks
• Interest rates environment makes discounting challenging
• High rates of traditional insurance makes demand for non-traditional
products high but supply low as reinsurers concentrate on “bread and
butter” products
Aside - Regulation
• FASB 113 (USA) requires transfer of underwriting and timing risk as
well as “significant” risk of loss for reinsurers
• EITF 93-96 (USA) – cedants must show balances of experience
accounts in balance sheet if obligation to ultimately repay
• FRAG 35/94 (UK) – more pragmatic, relies on economic substance of
transaction, timing risk only is allowable
• Post Enron - Executives required to sign-off on accuracy of accounts
• Move away from fixed accounting rules to true and fair view
Choosing a product and provider
Choice of provider
• Dictated by nature of product and current accounting/financial
environment
• Need provider that will offer partnership in product design, and in
pricing
• Absolute transparency with all parties is key – auditors, regulators,
management, investors
• Need reinsurer that can price and provide traditional risk transfer as
part of product
Choice and evaluation of product
• Work in partnership with reinsurer
• Start with insurers problem not reinsurers “off the shelf” solution
• Identify key financial measures which wish to protect or key financial
aims
• E.g. Balance sheet protection, maintain security rating, stabilise
combined ratio, tax efficiency
• Need to perform stochastic analysis of key financial ratios before and
after deal
• Look at accounting and economic effect
Assessment of risk
14.0%
Probability
Mode
12.0%
10.0%
8.0%
6.0%
5%
probability
of losing
more than
10% of
premiums
4.0%
2.0%
0.0%
-35%
-10%
0%
+25% (Average)
Profit as % of premium
+75%
Checklist
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Informed Purchase
Reason for Buying
Transparency of inner workings
Credit and Operational Risk in addition to Insurance Risk
Treat as a banking transaction
Tax and Regulatory arbitrage not drivers of deal
Consider pro-forma impact
Discuss with supervisors / agencies in advance
Agree up front early termination process
Sign and issue policy before
commencement
Non-traditional solutions for
Liability Exposures
Discussion / Questions