Business Organizations have always been exposed to various types of risks such as:
- Market Risks
- Credit and Insolvency Risks
- Operational Risks
- Statutory and Regulatory Risks
- Environmental and Climate Change Risks
- Exchange Rate Risks
- Legal, Reputational and Cyber Security Risks
- Risks related to bilateral, regional or international trade agreements between nations
- Risks related to politics, economic policies, environmental policies, etc.
- Risks related to Industrial Relations, general socio-economic conditions, and so on.
- Other Risks specific to the lines or sub-lines of business pursued
Events of the year 2008 had revealed the darkest manifestation of some of these risks, causing an avalanche of systemic failures, in turn resulting in a global financial meltdown. Affected Business Organizations had ignored or underestimated these latent risks only at their peril and had to pay an unprecedented price for it, causing a domino effect on others. Now again the COVID 19 pandemic promises to prove more disastrous and long-drawn-out on a never-before-experienced global scale.
The Insurance Institute of India defines that:
- Risk is the possibility of adverse results flowing from any occurrence.
- Risk is a condition where there is a possibility of an adverse deviation from a desired outcome – there is no requirement that the possibility be measurable, only that it must exist.
The Insurance Institute of India defines that:
- Risk Management is the identification, analysis and economic control of those risks which can threaten the assets or earning capacity of an enterprise.
Risk Management comprises of:
- Risk Identification
- Risk Analysis
- Risk Control:
- Physical risk control
- Financial risk control – Retention & Risk Transfer
Methods of Risk Management
Business Organizations deploy a combination of the below-mentioned methods of risk management:
- Risk Avoidance
- Risk Retention
- Risk Reduction
- Risk Pooling
- Risk Combination
- Risk Hedging
- Risk Transfer including Insurance
It is clear from the above that Risk Transfer is only one of the methods of Risk Management and that Insurance is only one of the methods of Risk Transfer.
Insurance Technical Risks
The International Association of Insurance Supervisors (IAIS) defines that:
“Insurance Technical Risks (liability risks) represent the various kinds of risk that are directly or indirectly associated with the technical or actuarial bases of calculation for premiums and technical provisions in both life and non–life insurance, as well as risks associated with operating expenses and excessive or uncoordinated growth.
Technical risks result directly from the type of insurance business transacted. They differ depending on the class of insurance. Technical risks exist partly due to factors outside the company’s area of business activities, and the company often may have little influence over these factors. The effect of such risks – if they materialize – is that the company may no longer be able to fully meet the guaranteed obligations using the funds established for this purpose, because, either the claims frequency, the claims amounts, or the expenses for administration and settlement are higher than expected. When considering the technical risks, IAIS proposes distinguishing between “current risks” and “special risks”.
Current risks consist of the following elements:
- risk of insufficient tariffs,
• deviation risk,
• risk of error,
• evaluation risk,
• reinsurance risk,
• operating expenses risk, and
• risks associated with major or catastrophic losses or accumulation of losses caused by a single event.
As to the special risks, they can be considered to consist of the following:
- risk of excessive or uncoordinated growth, leading to a rapidly increasing claims ratio or an aggravated expenses ratio, and
- liquidation risk.”
Insurers and Reinsurers face many of the same risks that other Business Organizations face. However, for purposes of this Technical paper, we shall confine ourselves to Insurance Technical Risks or Insurance Risks as defined above for Insurers. What is stated in this Technical paper applies to a great extent also to Reinsurance Technical Risks or Reinsurance Risks faced by Reinsurers.
Insurance Risks are basically inherited through direct insurance business, inward coinsurance business and inward reinsurance business of an insurer as reduced by risks ceded through outward coinsurance business, outward reinsurance business and other means. Similarly, Reinsurance Risks are basically inherited through inward reinsurance business of a reinsurer as reduced by risks ceded through outward retrocession business and other means.
Insurance Technical Risks Analysis
The insurance business is all about risk – understanding it, minimizing it, pricing to compensate for it.
Insurance risk analysis methods are mentioned below:
- Insurance risk factor profiling
- Insurance predictive modelling
- insurance risk modelling
- Insurance scoring
- Insurance risk-level classification
Insurance Technical Risks Management
Presently, insurers manage insurance risks through the seven methods mentioned earlier. More particularly:
- Insurance Risk Avoidance: Insurers may avoid accepting certain specific risks, certain sub-lines or lines of business altogether, or business in certain geographies or hazardous locations.
- Insurance Risk Retention: Insurers may retain certain insurance risks either deliberately, through inadvertence or due to market conditions. In the first case, insurers may retain certain insurance risks found more profitable to retain, or as per the retention obligations imposed by the reinsurance arrangements, or which are not covered under the existing coinsurance or reinsurance arrangements and facultative cover is either not available or available at unacceptable rates or terms and conditions.
In the second case, insurance risk retention may be forced by inadvertently failing to make other arrangements so that the insurer is (so to say) ‘left holding the baby’.
In the third case, market conditions may be adverse such that other arrangements can be made only at uneconomical rates or unfavourable terms and conditions. Hence, insurance risk is unwillingly retained.
- Insurance Risk Reduction: Insurers reduce insurance risks accepted, through various mechanisms such as policy deductibles, co-pay, exclusions, warranties, terms, conditions, no claim bonus, other rewards to the insured for good claims history, requirement of material changes to be intimated, working with the insured to mitigate risk, working with loss prevention associations, working with governmental agencies, creating awareness among policyholders, and so on.
- Insurance Risk Pooling: Insurers participate in pools within the country such as Indian Market Terrorism Risk Insurance Pool, Indian Nuclear Insurance Pool and Motor Third Party Insurance Pool (the last mentioned has now been disbanded). Pooling may also be regional or global.
- Insurance Risk Combination: Insurers may combine a large number of small or medium, widely dispersed insurance risks in the same sub-line or line of business in their portfolio instead of a few large insurance risks. Such a combination may be relatively more feasible to retain to a larger extent. Also, they may opt for an ideal mix of insurance risks among various sub-lines and lines of business, so that adverse results in one may be offset by favourable results in others in a particular year. Further, they may combine good insurance risks (few available), average insurance risks (relatively more available) and poor insurance risks (the largest number available) in such a way that the first category is fully retained, the second category is partially retained and the last category is fully transferred.
- Insurance Risk Hedging: Insurers hedge insurance risks through the operation of the Law of Large Numbers. As the number of risks increases in a portfolio, the number of losses also increase, but less than proportionately. If one out of ten factories insured reports a fire loss, it does not mean that ten out of hundred or hundred out of a thousand factories insured will report fire losses. So the insurance risk is hedged, not by taking a contrary position, but by offsetting it through a far larger number of similar risks.
- Insurance Risk Transfer including Coinsurance and Reinsurance: How an insurer shifts back a certain portion of insurance risks to the insured has been discussed under “Insurance Risk Reduction”. An insurer can transfer the insurance risk to third parties under the Principle of Subrogation. An insurer may share the insurance risk with other insurers through the mechanism of Coinsurance. Finally, the residual insurance risk may be transferred through Reinsurance arrangements.
Insurers also manage insurance risks through techniques including but not limited to:
- Prudent selection of lines of business, geographies, etc.
- Deployment of astute business processes, competent personnel and appropriate software
- Prudent selection from business offered
- Sound underwriting including rating, terms, conditions, exclusions and warranties
- Guarding against risk accumulation hazards and catastrophe hazards
- Guarding against moral hazards including insurance fraud
- Claims investigation, salvage, subrogation, legal remedies, etc.
- Control over expenses of administration and settlement
- Building up of technical and other reserves
- Optimizing investment income to supplement underwriting profits or to offset underwriting losses
- Coinsurance and reinsurance
- Alternative Risk Transfer (ART) including Special Purpose Vehicles (SPVs)
Insurance Risk Management is already a few centuries old. Is it then not refined enough?
The root cause of the problem lies not only in the departmentalization of insurance companies but also in the understandably differing mindsets of marketing, underwriting, claims, reinsurance and investment personnel and in the ingrained mentality of personal fiefdoms of key executives.
For instance, when a decision is taken to cede business to a reinsurer, rarely is the investment department consulted to calculate the opportunity cost of the investment income lost (on the premium ceded less the reinsurance commission and profit commission earned) vis-à-vis the claims likely to be paid out on the risk proposed to be ceded, if not ceded. That decision is taken in isolation, leading to less than optimum return on capital employed on insurance technical risk management.
Similarly, investment decisions are considered to be too confidential, sacrosanct and unintelligible for the uninitiated to be discussed with the likes of personnel of ‘less informed’ departments. Those decisions, too, are taken with utmost secrecy, leading to lack of coordination, avoidable retractions and, ultimately, less than optimum ROCE on ITRM, not to mention undoing all the good work done by sound underwriting. Events of year 2008 have given cause enough to cast serious aspersions on the so-called financial management expertise of investment experts.
For insurers, risk can contain valuable upside, if managed effectively. An insurer that understands how risk might impact its Key Performance Indicators (KPIs) can move more effectively to seize opportunities and drive business performance.
The strategies that insurers develop for financing risk are an important part of this process. By simply reinsuring, insurers probably miss an opportunity to extract better value from their capital. Sub-optimal decisions on financing risk can impact Key Financial Indicators (KFIs) and erode margins.
Investment trend for insurers has to move towards managing risk rather than buying more reinsurance – taking greater control over their risk-related costs. By better managing their exposure to the reinsurance market cycle, through improved risk management and alternative financing arrangements, insurers are reducing the volatility of their risk financing cost base and creating value for their businesses.
Insurance Technical Risk Management Optimization (ITRMO) describes the course of action which insurers have to follow in order to arrive at optimal risk financing arrangements, typically resulting in a sustainable and lower total cost of risk. It draws on information and people from all across the insurer’s business, encouraging them to offset investment in mitigation and management strategies with a reduction in cost of risk, and to counterbalance expenditure on reinsurance with realistic retentions.
One of the guiding principles of ITRMO is to treat the use of reinsurance not as a written off commodity spend, but as a third source of capital, over and above debt and equity. As well as providing protection, it can help to optimize the cost of capital.
The case for ITRMO
Insurance Technical Risk Management Optimization (ITRMO) describes the strategic process undertaken by insurers to make balanced and objective decisions around the allocation of capital to risk. Its fundamental principles are:
- It considers the purchasing of reinsurance as only one of a number of tactics that can be deployed, as part of a broader, often more long term risk management and financing strategy. ITRMO is about more than the limits and deductibles of a reinsurance arrangement.
- It treats reinsurance and risk financing spend as a form of capital allocation, with the potential to work harder and deliver a higher return when allocated in a more optimal way.
- Ultimately it describes the matching of an insurer’s buying style with its appetite to take risk, the losses it is likely to sustain and the cost of capital associated with its various financing options.
An insurer’s total cost of risk (TCOR) can be calculated by adding the expected cost for the risk it chooses to retain to the cost of its reinsurance, while also accounting for the cost of capital assumed for unexpected volatility.
TCOR cost of retained losses + cost of capital (including statutory reserves) + cost of external risk transfer + taxes
The cost of purchasing reinsurance might become more expensive in relative terms than the cost of capital for retaining the risk. There risk-adjusted return on capital (RAROC) is negative – i.e. no value is being created from purchasing reinsurance.
The reverse may also be true. An insurer with high retentions may find that over time a reinsurer’s risk-adjusted return on capital (RAROC) is a lower cost – here it would be more optimal to transfer the risk.
Reinsurance coverage can be accurately matched to exposures and loss expectancies. Exposures not reinsurable can be identified and assessed, and alternative forms of financing arranged to manage potentially major losses. Areas on which to focus risk improvement or management activity can be identified, with the investment budget determined by or even offset against the potential reduction in losses or savings in risk transfer.
The ITRMO process
Stage 1 – Understanding the strategy and current position of the insurer’s business
The information that an insurer should gather to inform its subsequent decisions on risk would include:
- Historic claims experience
- Existing risk registers
- Benchmarked risk data from insurer peer groups
- Corporate attitudes to risk – insurer as risk-taker or risk-avoider
- Gaps in required underwriting information and develop parameters and systems for optimum data collection
Stage 2 – Analyzing and modelling data
Turning data into meaningful decision making tools forms the second, critical stage of the ITRMO process. The goal is to identify the optimal structure for the risk financing programme, against which reinsurance coverage can be overlaid.
This stage is focused not only on identifying optimum reinsurance arrangements, but also in determining the amount and type of risk that can be retained by the insurer. Typical considerations in this stage include:
- Technically reviewing current coverage, limits and exclusions, in order to stress-test the adequacy of existing reinsurance arrangements against the risks identified in Stage 1.
- Calculating risk tolerance: insurers must evaluate whether changes to their business, its strategy and its financial strength could mean that current levels of reinsurance no longer represent the best form of capital for financing risk. This stage will help determine the insurer’s materiality threshold and transfer ‘strike points’. A variety of indicators can be followed to determine risk appetite and the willingness or ability of the insurer to pay for losses from their own liquid reserves. These include credit ratings, materiality thresholds, industry benchmarked retention levels or ‘rules of thumb’. Besides ensuring more effective deployment of capital, this process can help insurers reduce the volatility attached to reinsurance market cycles, by buying potentially protection at higher levels.
- Using the analysis on risks, existing reinsurances and optimal retention levels, insurers are then in a position to develop actuarial models – sometimes called ‘integrated loss models’ –that enable them to design various programme structures, balancing a range of theoretical transfer and retention costs. The objective at this stage is to identify the lowest TCOR, allowing for self-reinsured volatility.
- Analysis of Alternative Risk Financing options, including captive feasibility studies: If a company has concluded that it is potentially overspending on reinsurance, then it might consider setting up a captive reinsurance vehicle to self-finance some of its risk.
For each class of exposure under consideration, it is necessary to define (for any level of per occurrence deductible):
- the appropriate aggregate stop loss
- the retained risk fund required at a given confidence level
- reinsurance pricing
- the cost of risk [this being the sum of (retained losses) + (reinsurance premiums ceded less reinsurance commission and profit commission) + (cost of capital including statutory reserves) and (taxes)]
This helps insurers to establish the cost benefit of each of the options generated in relation to the current basis – for each class of risk (mono-line) and as an integrated risk (multi-line) financing programme. It then prioritises the options to define the optimum programme design.
Stage 3 – Designing and placing insurance risk financing solutions
Work done in the above two stages will now help determine the appropriate reinsurers to approach. Any work an insurer has done to identify its exposures, build an integrated risk financing strategy and potentially managing down the causes of claims, should help it obtain better terms in the reinsurance market.
Cessions to reinsurers should contain detailed and relevant data on the extent of the risks, the performance of controls and their correlation with losses and the insurer’s commitment to improving risk profile. Given such available and transparent information and performance metrics, reinsurers will often offer financial incentives to insurers who implement a programme of ongoing risk improvement, by either increasing reinsurance commissions or contributing to risk management initiatives.
The reinsurance placement will be complemented by the structure of alternative risk financing and transfer solutions to ensure the overall return on capital invested in risk is optimised for the company.
As stated earlier, what is true between an insurer and a reinsurer is also true between a reinsurer and a retrocessionaire and so on. A unique domain-technical solution incorporating elements of financial modelling, actuarial science and insurance market methodologies, further customized for each specific insurer, is the all-encompassing holistic solution to optimizing insurers’ return on capital employed on insurance technical risk management.
The net result of this would be sustained financial and business benefits. Needless to add, the solution needs to be reviewed for adequacy and optimality on a regular basis and changes, if required, incorporated.