Economic Benefits of
Integrated Risk Products
Lawrence A. Berger
Swiss Re New Markets
CAS Financial Risk Management Seminar
Denver, CO, April 12, 1999
Session: Innovative Approaches to Managing Financial Risk
1
Integrated contracts combine several risk lines over several
years into a product with common retention and coverage
Financial Line 2
Financial Line 1
3
Insurance Line 2
Years
Insurance Line 1
Coverage
Coverage
Single Line vs. Integrated Program Design
2
Years
3
2
1
1
Traditional single line approach
• Yearly renewals
• Separate lines
• Many providers
• Cost intensive
Integrated approach
• Multi-year
• Multi-line
• One provider
• Cost efficient
2
Integrated coverage is a more efficient way to provide
insurance capacity
One block of capacity is available to meet all losses.
Across lines of insurance
Across financial exposures
Across time
Unused capacity from one risk is available to fund losses from
other risks.
Unused capacity from one year is available to fund losses
from future years.
3
Integrated coverage is a more efficient way to provide
insurance capacity
Single Lines
Insurance
and
Financial
Capacity
Integrated
Solution
Insurance
Loss
Insurance
Capacity
Loss
Experience
Financial
Capacity
Financial
Loss
Retention
Retention
Retention
Retention
4
Retention
Integrated coverage is a more efficient way to provide
insurance capacity
Integrated
Solution
Not
Covered
Unused
Capacity
Financial
Loss
Single
Lines
Unused
Capacity
Insurance
Loss
Insurance
Loss
Financial
Loss
5
Integrated contracts provide a superior coverage structure
compared to single line contracts
Coverage with two
single lines
Line 1
Coverage with limits
Line 1
200
50
50
50
50
Line 2
200
Line 2
6
Integrated contracts provide a superior coverage structure
compared to single line contracts
Integrated coverage enables a
superior risk management
technology:
Integrated Coverage
• New full coverage for large
combined losses regardless of
their composition (A)
Line 1
Line 1
400
• Elimination of coverage for low
losses in one risk line if the loss in
the other risk line is relatively
small (B)
A
• Covers low frequency, high
severity events. Insured retains
high frequency, low severity risks.
200
100
B
50
A
B
50
200
100
Line 2
400
Line 2
7
Cost Savings
Cost savings can range from 10-20% when the
probability of losses in area A is considerably less
than area B.
Alternatively, retention can be lowered and/or
capacity can be increased to be comparable in
cost to single line coverage.
8
Quantifying the Benefits
How to include the higher expected retention?
Utility theory approach:
Expected utility is higher for the purchaser of an
integrated cover than for the purchaser of an
unbundled cover with the same cost.
9
DFA Analysis
Economic
and
Asset
Simulation
A
Measurable
Financial
Risk
Optimization
& Valuation
M10
Liability &
Business
Simulation
L
A simulation model is used to project possible future
economic and capital market conditions.
Key Outputs
Key Inputs


Interest rates, inflation, P/E
ratios, GDP, currency
strength, alternative yield
curve factors
Asset class characteristics
and parameters
Economic and
Capital Market
Simulation
Model
11

500 - 1,000 or more
stochastic (random)
economic and capital
market scenarios

Asset class total returns,
broken down into income
and capital appreciation
Interest rates are simulated to capture year-to-year
volatility and its impact on financial results...
90-day T-bill
12.0%
10.0%
Rate
8.0%
6.0%
4.0%
2.0%
0.0%
12/31/96
12/31/97
12/31/98
12/31/99
12
12/31/00
12/31/01
...to reflect the risk exposure of alternative investment strategies.
Average Annual Returns
60
Cash
Bonds
1-5 year
Bonds
5-10 year
Equities
Percentile
95th
75th
50th
50
25th
Total Return (%)
5th
40
30
20
10
0
-10
-20
Mean
Standard Dev.
6.0%
1.5%
6.7%
4.6%
7.1%
9.5%
13
11.0%
20.6%
Liabilities are simulated to create a picture of current and future
premium, loss and expense cash flows.
Key Inputs

Existing reserve data &
characteristics

Business Plan
assumptions (3-5 yrs)
Key Outputs
Liability
Simulation
Model
14

500 - 10,000 stochastic
liability scenarios

Distribution of existing
reserve cash flows

Distribution of new
business cash flows
The asset and liability scenarios are put together to assess
risk and reward opportunities.
Key Inputs

Economic and asset
scenarios

Liability and business
scenarios

Key Outputs/Uses
Optimization
& Valuation
System
Financial data (statutory,
GAAP, tax)

Objectives and constraints

Sensitivity testing
15

ALM efficient investment
strategies (surplus risk &
reward)

Stochastic financial
statements

Risk Management Analysis

Strategic business
applications
Statutory Surplus Risk Profile
Statutory Surplus
Years 1 - 3
590,000
540,000
490,000
440,000
390,000
340,000
290,000
240,000
Yr 1 Current Reins
5% to 25%
Yr 1 Agg Excess
Yr 2 Current Reins
5% to 25%
Yr 2 Agg Excess
25% to 50%
16
Yr 3 Current Reins
50% to 75%
Yr 3 Agg Excess
75% to 95%
GAAP Income Risk Profile
GAAP Income
Years 1 - 3
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
Yr 1 Current Reins
Yr 1 Agg Excess
5% to 25%
Yr 2 Current Reins
Yr 2 Agg Excess
25% to 50%
Yr 3 Current Reins
50% to 75%
17
Yr 3 Agg Excess
75% to 95%
Capital Markets Coverages
Equities
Interest Rates
Foreign Exchange
Corporate Bond Defaults
Commodities
18
Equity Market Risk
Company 1 is a mutual company with a large
position in equities due to the runup in equity
values.
Management is concerned about future declines
in value.
Solution: Combine reinsurance protection with
protection against declines in the S&P 500.
Provide aggregate excess of loss where retention
is reduced with declines in S&P.
Protects against impact of equity market declines
on income and surplus.
19
Equity Market Risk
Provides cost savings for a company that buys
reinsurance and equity market protection separately.
Provides expanded protection at additional cost for a
company that does not currently hedge its equity
position.
Alternatively, an Integrated Collar approach can be
used to provide equity market protection at no
additional cost (see below).
20
Interest Rate Risk
Company 2 is a stock company with a large
position in corporate and government bonds.
Management is concerned about the potential
impact of increases in interest rates on net worth.
Solution: Combine reinsurance protection with
protection against increases in interest rates.
Provide aggregate excess of loss where retention
is reduced with increases in an interest rate index.
21
Combined Capital Markets Coverage
If Company 2 is also concerned about equity
market declines, retention can be reduced with an
increase in interest rates and/or a decline in the
S&P 500 in one combined cover.
22
Corporate Bond Defaults
Company 3 has a large position in corporate
bonds. Management is concerned about the
potential impact of corporate bond defaults on
surplus.
Solution: Combine reinsurance protection with
protection against corporate bond defaults.
Aggregate excess of loss is extended to include
losses on corporate bonds as insurable coverage.
23
Combined Capital Markets Coverage
A company with exposures to equity markets,
interest rates and corporate bond defaults can
include all of these risks in an integrated cover
together with traditional reinsurance.
24
Integrated Collar
Aggregate Excess of Loss where retention goes up or
down depending on performance of capital markets
exposures.
Example: Retention moves up when S&P goes up by
more than 15% in one year. Retention moves down
when S&P goes down by more than 5% in one year.
25
Integrated Collar
Can be designed to add no additional cost to the
aggregate cover.
Retention can also move with interest rates, or can
move with the S&P and/or interest rates in a
combined cover
26