Risk Mitigation through Reinsurance and Other Means May 11, 2007

1. Risk Mitigation through Reinsurance and Other Means May 11, 2007 ASSAL – VIII Conference on Insurance Regulation and Supervision in Latin America Regional Seminar on Capital Adequacy and Risk-based Supervision Bryan Fuller - NAIC Senior Reinsurance Manager

2. Outline • Purposes and Benefits of Reinsurance • Types of Reinsurance • Risk Management Framework • Alternative Risk Transfer • Captives, Finite Risk, Contingent Capital • Derivatives, Securitization

3. Elements of Reinsurance • Reinsurance is a form of insurance. • There are only two parties to the reinsurance contract - the Reinsurer and the Reinsured - both of whom are insurers, i.e. entities empowered to insure. • The subject matter of a reinsurance contract is the insurance liability of the Reinsured undertaken by it under insurance policies issued to its own policyholders. • A reinsurance contract is an indemnity contract.

4. What Reinsurance Does 1. It converts the risk of loss of an insurer incurred by the reinsured under its policies according to its own needs. 2. It redistributes the premiums received by the reinsured, which now belong to the reinsured, according to its own business needs.

5. It is not Alchemy. • Reinsurance is not banking – it is not the lending of money but it can have the same effect. • Reinsurance is not a security. What Reinsurance Does Not Do Reinsurance does not: • Convert an uninsurable risk into an insurable risk. • Make loss either more or less likely to happen. • Make loss either greater or lesser in magnitude. • Convert bad business into good business.

6. Five Functions of Reinsurance • 1. Capacity / Spreading Risk • Ability to write more premium while maximizing • principle of insurance. • 2. Loss Control / Catastrophe Protection • Minimize financial impact from losses. • 3. Financing • Providing financial resources for growth. • 4. Stabilization • Minimize variations in financial results. • 5. Services • Facilitate operations of insurance companies.

7. Capacity • Refers to an insurer’s ability to provide a high limit of insurance for a single risk, often a requirement in today’s market. • Reinsurance can help limit an insurer’s loss from one risk to a level with which management and shareholders are comfortable. • Most states require that the maximum “net retention” from one risk must be less than 10% of policyholders’ surplus.

8. Catastrophe Protection • Objective is to limit adverse effects on P&L and surplus from a catastrophic event to a predetermined amount. • Covers multiple smaller losses from numerous policies issued by one primary insurer arising from one event.

9. Financing • It is growing and needs additional surplus to maintain acceptable premium to surplus ratios. • Unearned premium demands reduce surplus. • In a down cycle, underwriting results are bad and reduce surplus. • Investment valuation negatively impacts surplus. • Marketing considerations dictate that an insurer enter new lines of business or new territories.

10. Stabilization Marketing Consideration Policyholders and stockholders like to be identified with a stable and well managed company. Management Consideration Planning for long term growth and development requires a more stable environment than an insurance company’s book of business is apt to provide.

11. Services 1. Claims Audit 2. Underwriting 3. Product Development 4. Actuarial Review 5. Financial Advice 6. Accounting, EDP and other systems 7. Engineering - Loss Prevention

12. Reinsurance Contracts Basics Proportional Reinsurance Non-Proportional Reinsurance Reinsurance Contracts Treaty Facultative Semi Automatic Pro Rata Excess of Loss Certificate OR Automatic Quota Share Surplus Share Per Risk Per Occurrence Aggregate Pro Rata Excess of Loss • Other Considerations: • Occurrence vs. Claims Made • Prospective vs. Retroactive

13. Facultative Protects individual risks Offer and acceptance basis. Reinsurer retains the right to accept or reject each risk. Supported by a Certificate Certificate attaches to the conditions on the underlying insurance policy Cession is optional Treaty Protects a large block of business. The reinsurer does not have the right of rejection on a per risk basis. Supported by a contract Pre-agreed conditions Cession is obligatory Acceptance is automatic Reinsurance Forms Book of Business Individual Risk

14. Types of Agreements Proportional • Quota Share • Surplus Share • Excess of Loss

15. Types of Agreements Quota Share: Simplest type, reinsurer and reinsured share in every loss and in the premiums at a fixed percentage. Example: Retention 80% / Reinsurance 20% Policy Limit $100,000 $200,000 Retained Amount – 80% $ 80,000 $160,000 Reinsured Amount – 20% $20,000 $40,000

16. Impact of Quota Share

17. 80% Quota Share

18. Types of Agreements Surplus Share: Greater flexibility. Reinsured selects retention each risk, and cedes multiples of the retention (lines) to the reinsurer. Compared ceded amount to policy limit. Create a proportion. Reinsurer chares in that proportion of loss and premiums for each loss under that policy. Policy Limit $20,000 $40,000 $60,000 Reinsured’s Share 100% 50% 33.33% Reinsurer’s Share 0 50% 66.66%

19. Quota Share Vs. Surplus Share Both Always Pay Proportionate Share of Any Loss QS Surplus Cession % Varies Based on Size of each Risk and ceding company retention Cession % the Same for every risk Protects Cedent’s Entire Book Used Mostly for Larger Risks Always Obligatory Can Be Obligatory or Non-Obligatory

20. Excess Of Loss Reinsured retains a predetermined dollar amount (the retention). The reinsurer then indemnifies loss excess of that retention up to a stated limit. • Per risk excess of loss • Per risk aggregate excess of loss • Per occurrence excess • Aggregate Excess of Loss (Catastrophe)

21. Excess Of Loss With excess of loss reinsurance no insurance is ceded and no sharing is involved. The reinsurer promises to reimburse the reinsured company for losses above a set retention in return for a stated premium rather than promising to share premiums and losses based on some proportional basis Excess of loss reinsurance is frequently provided in layers with the retention at each layer equal to the reinsured company’s retention plus the reinsurance limit of the layer(s) above. As the limits of the layer are exhausted the next layer of excess reinsurance becomes available.

22. 20 $ 10 M 95% of $ 5M xs $ 5M Catastrophe Excess of Loss Cover $ 5 M 95% of $ 4M xs $ 1M $ 1 M 95% $ 500K xs $ 500K $ 500 K Retention

23. Impact of Excess of Loss

24. Impact of Excess of Loss

25. Types of Agreements

26. Reinsurance Program Example Catastrophe Non-Proportional 2nd Excess 1st Excess $ Loss Surplus Share Proportional Quota Share Retention

27. Purpose of Reinsurance Regulation • Police the Solvency of Reinsurers and Ceding Insurers • Ensure the Collectability of Reinsurance Recoveries • Establish and Maintain a Method of Accurate Reporting of Financial Information Relied Upon by Regulators, Insurers and Investors • Lacks the Consumer Protection Component Necessary for Primary Insurers • Focuses on the Reinsurance Transaction

28. Regulation of Reinsurers • U.S. reinsurers are subject to the same entity regulation as U.S. primary insurers, e.g., risk-based capital, holding company laws, state licensing laws, annual statement requirements, triennial examinations and investment laws. • The exception is no regulation of rates and forms.

29. Risk Management Framework Insurer key risks might be categorized under the following major headings: • Underwriting • Credit • Market • Operational • Liquidity • Strategic

30. Underwriting • Underwriting risks are those associated with both the perils covered by the specific line of insurance (fire, death, motor accident, windstorm, earthquake, etc.) and the risk mitigation processes used to manage the insurance business.

31. Underwriting • Underwriting Process Risk • Pricing Risk • Product Design Risk • Claims Risk (for each peril) • Economic Environment Risk • Net Retention Risk • Policyholder Behavior Risk • Reserving (Provisioning) Risk

32. Credit Risk • Credit risk is the inability or unwillingness of a counterparty to fully meet its on- or off balance sheet contractual financial obligations. The counterparty could be an issuer, a debtor, a borrower, a broker, a policyholder, a reinsurer, or a guarantor.

33. Credit Risk An insurer might define its credit risk in terms of: • Asset classes in which it is willing to invest • Government and corporate bonds, mortgages, equities, etc. • Type of credit activity, collateral security, or real estate and type of borrower; • Range of exposures in each asset class • Government bonds 10–20%, marketable corporate bonds 20–40%, mortgages 10–30%, equities 5–10%) • Maximum exposure to a given credit, issuer, industry sector, or counterparty • Chosen to limit the possible impact of a default on the surplus of the insurer) • Transactions or exposures involving connected or related entities.

34. Market Risk • Market risks relate to the volatility of the market values of assets and liabilities due to future changes of asset prices(/yields/returns). In this respect, the following should be taken into account: • Market risk applies to all assets and liabilities.

35. Market Risk • Market risk must recognize the profit sharing linkages between the asset cash flows and the liability cash flows (e.g., liability cash flows are based on asset performance). • Market risk includes the effect of changed policyholder behavior on the liability cash flows due to changes in market yields and conditions.

36. Operational Risk • The identification of insurer operational risk involves considering all the key functional areas of the insurer from each of the following perspectives: • Human capital risk (for example, employing people with the appropriate skills and experience) • Management control risk (for example, including appropriate sets of controls ininternal processes and using and communicating those controls effectively)

37. Operational Risk • System risks (for example, ensuring that systems used in the operation of the insurer are adequate, appropriate, reliable, and scalable, and have adequate security, backups, and disaster recovery plans) • Strategic risks (for example, addressing threats to operations from competitors) • Legal risk (for example, complying with all laws and regulations in the jurisdictions in which the insurer operates; employing best business practices and standards of corporate governance; pro-actively addressing policyholder expectations).

38. Risk Aggregation

39. Solvency I - Reinsurance • According to the present EU legislation (Solvency I) you will get a relief on capital up to 50 % for non-life insurance (30 % quota share will give 30 % relief while 60 % will give 50 %). This will change with Solvency II and the quality of the reinsurer will also be taken account of in the form a credit risk rating.

40. Solvency II - Aims • Establish solvency standard to match risks • Encourage risk control in line with IAIS principles • Harmonise across the EU • Assets and liabilities on fair value basis consistent with IASB if possible

41. Solvency II – New Regulations • Some European supervisors are already attempting to meet the aims set for Solvency II • United Kingdom, Switzerland, Sweden (Life Insurance Only) • In all cases, the new regulation is based on marking assets and liabilities to market and capital requirements based on scenario tests or economic modelling.

42. Findings – Technical Provisions • Problem areas noted were: • Lack of resources, time and experience • Lack of data and choosing actuarial assumptions • Derivation of Risk Margins • Treatment of Reinsurance • Wide range of methods used by companies to produce results

43. Credit Risk – Factor Approach SCR credit risk = MV of exposure * duration * factor

44. Solvency II – Reinsurance Implications • Reinsurance constitutes exchange of insurance risk (primarily underwriting & accumulation) for asset risk: • Asset risk carries a lower capital charge than insurance risk, thus reinsurance can be an effective way to manage regulatory capital needs • Factor based models do not distinguish between proportion and non-proportional reinsurance • Risk mitigating effect of non-proportional reinsurance compared to ceding of profits are reflected more adequately within simulation based models

45. Effect of Reinsurance on Solvency Rules • Reinsurance provides: • Capital relief in MCR (Minimum Capital Requirement) and SCR (Solvency Capital Requirement): • Rating of Reinsurers to be factored in - • The higher the rating of a reinsurer the lesser capital is needed • Increasing tendency to cover credit risk arising from reinsurance recoverables • Retrospective and prospective coverage reinsurance solutions • Concentration of Credit Risk • UK FSA monitors annual premium ceded to one reinsurer (20%) and total recoverables from any one insurance group to not exceed 100% of capital resources

46. Risk Based Capital Due to the diversification ability of the reinsurer, more capital is freed up on the cedent’s side than is bound on the reinsurer’s side. Therefore, the cost of assuming the risk is lower for the reinsurer than for the cedent.

47. U.S. RBC Reinsurance Charge • 10% charge for reinsurance recoverables. • Rationale for the Reinsurance Charge • The apparently high charge on reinsurance recoverables was motivated by reinsurance collectibility problems contributed to several major insurance company insolvencies in the mid-1980s. • Criticism of the Reinsurance Charge • Incentives: • Quality of Reinsurer: • Collateralization.

48. Types of Life Reinsurance • Indemnity • Traditional Spread or Lessen Risk • Financial Meets Financial Goals • Non-Proportional Catastrophe, Stop Loss • Retrocession Reinsurance of Reinsurance • Assumption • Transfers Business Permanently

49. Reasons for Indemnity Reinsurance • Transfer Mortality/Morbidity Risk • Transfer Lapse or Surrender Risk • Transfer Investment Risk • Help Ceding Insurer Finance Acquisition Costs

50. Reasons for Indemnity Reinsurance • Provide Ceding Company • Underwriting Assistance • Product Expertise • Tax Planning • Help Manage Capital and Surplus and/or RBC Objectives • Limit Adverse Effects of Catastrophic Events • Help Enter New Market