Aligning Reinsurance with Corporate Strategy: A DFA Approach

1. CAS Seminar on Risk and Capital ManagementDFA-7: DFA and ReinsuranceUsing DFA to Align Reinsurance with Corporate StrategyRaju Bohra FCASVice-President, American Re-Insurance1234

2. Discussion Outline • Aligning reinsurance with corporate strategy • Typical DFA process • Case study

3. IntroductionComments and Caveats • Reinsurance analysis has been the “Killer Application” for DFA • Focus on DFA application, not much on model building and parameterization • Will not deal with asset and economic modeling side of DFA modeling but it can be incorporated

4. DFA, Reinsurance, and Corporate Planning

5. Strategic Planning Financial objectives Surplus growth Earnings stability Threats Extreme events Volatility Rating agencies Financial pro forma’s Detailed (BS, IS, CF) Summary reinsurance“Net-to-Direct” ratios Reinsurance Purchasing Old habits Rules of thumb XOL ret. < 1% of surplus Cat ret. < 5% of surplus Rating agency driven Budget or cost driven Only consider ceded premium as “cost” Uncertain how changes will impact financials DFA, Reinsurance, and PlanningCurrent Practices

6. DFA, Reinsurance, and PlanningBetter Process • Companies have a corporate strategy defined by their financial plans • DFA provides a link between these plans and their reinsurance purchases • Risk Management • Volatility of plan numbers • Impact of reinsurance on plan volatility • Financial Management • “Direct-to-Net” financial impact of reinsurance • More than Loss Ratios • Expenses • Investment income • Regulatory and Rating Agency ratios

7. DFA, Reinsurance, and PlanningBenefits of Process • Enhance reinsurance program design • Deeper understanding of liabilities • Quantify gross risk profile • Impact of reinsurance • Sensitivities to changes • Capability to evaluate reinsurance alternatives • Distill impact of programs into key statistics and charts • Tie reinsurance purchase to company’s strategic objectives • Traditional risk management • Capital management • Financial objectives

8. DFA, Reinsurance, and PlanningBenefits of Process • Holistic approach to reinsurance • Framework to analyze entire program • Analyze contracts and coverage terms as a whole • Measure “value” of reinsurance transaction • Go beyond seeing “cost = ceded premium” • See impact or risk reduction in financial plan • Provides objective basis for decision-making • Common “apples-to-apples” comparison • Quantifies risk-reward trade-off • Customized to company’s needs

9. DFA Process for Reinsurance

10. Typical DFA ProcessGeneral Overview • Use DFA simulation to model impact of alternatives reinsurance programs • Limit scope given objectives and timelines • Only model relevant detail • Simplified asset portfolio • Subject business groupings • Keep other sources of variation static • Economic variables • Reserve development • Model detail needed to support decision making Ranking of alternatives based on objectives

11. Typical DFA ProcessOutline of Process • Preliminary work • Identify company’s needs and objectives • Return – usually stated in accounting terms • Risk – volatility of return, usually downside • Modeling work • Select and define alternatives to compare • Analyze model output • Presentation • Interpret and discuss output • Create statistics and charts to evaluate options with respect to objectives

12. Typical DFA ProcessPreliminary Work • Must work closely with company • Understand company’s objectives • Return – What is their measure of success?Answers could be: long term SAP surplus growth, smooth or increase GAAP earnings, increase economic value, grow premiums, etc. Usually stated in accounting terms. • Risk – Why do they buy reinsurance?Answers could be: catastrophe potential, frequency of smaller events, volatility of results, leverage issues, support growth, etc.

13. Formal statistics Probability of ruin Expected policyholder deficit Tail VAR Variance, standard deviation Number of others Difficult for management to interpret Business related measures Probability of unfavorable operating result U/W Loss > $X Surplus decline > X% Rating downgrade Regulatory IRIS test failure Shows reinsurance program’s impact on management objectives Typical DFA ProcessPreliminary Work – Definition of “Risk”

14. Typical DFA ProcessModeling Work • Identify reinsurance alternatives • Terms, inuring, rates and commissions • Reinsurance premiums • Reinsurer or broker quote • Technical pricing • Gather data • Financials, reinsurance submission, Loss reserve study, catastrophe study, etc. • Create a consistent U/W model • Direct results by line • Net results by line • Ceded results by cover

15. Typical DFA ProcessModeling Work Diagram Model Insurance and Asset Portfolio Define Reins Structure Simulate Results Gross, Ceded, and Net Results, in Financial Accounting Framework Loss distributions Premiums Balance Sheet Limits Retentions Ceded Rates

16. Accounting Detailed pro forma’s Balance sheet Income stmt Cash flow Tax impacts Regulatory and Rating ratios BCAR IRIS Loss Modeling Flexible LOB’s Claim level Policy limits Correlation Events Occurrences Typical DFA ProcessModeling Considerations Reinsurance Modeling • Complex terms • Inuring structures • Loss sensitive features • Commissions • Profit share

17. Typical DFA ProcessAnalysis Work • Meet with company to discuss and interpret model results • What were the drivers of the model results? • How did the various structures/covers respond under the simulated conditions? • What results are not intuitive? Why? • Were the company’s objectives addressed? • Which structures make the most sense?

18. Hypothetical Case Study

19. InsureMetricsTM– Description Graphical User Interface Flexible detail level supports different needs – simple or complex

20. Reinsurance Alternatives