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How to Find Capital, Operating Efficiencies

Companies should review their use of intercompany reinsurance, through either individual or pooled quota share agreements. If insurance companies (particularly in the property & casualty (P&C) sector and possibly health maintenance organization (HMO) sector) can do this correctly, they can achieve capital and back-office operational efficiencies without disrupting “business-as-usual” front office operations.

Inter-company reinsurance efficiency opportunities

PwC sees opportunities for:

  1. Companies that have intercompany reinsurance pools or quota share agreements in place to become more efficient, and
  2. Companies that do not currently use or have limited intercompany pooling and quota share to expand the use of these concepts.

Increasingly, regulators are open to these modifications, provided policyholders are not put at a disadvantage.

A well-designed intercompany reinsurance structure can result in a number of efficiencies. Specifically, by establishing 100% quota share or 0% retrocession pooling agreements, a group of P&C companies can move all retention to a single “lead” company. The goal is to have the lead company retain the bulk of the insurers’ capital and investment portfolios while ceding companies maintain only minimum surplus levels. The lead company would become the only company where capital needs to be actively managed and would have a larger, consolidated investment portfolio.

Companies (particularly P&C) that retain a relatively large number of legal entities after simplification may find a single pooling agreement more straightforward than managing multiple affiliated reinsurance agreements. However, multiple quota share agreements may streamline future changes for events such as divestitures and acquisitions. Note that multiple agreements transferring business back and forth between the same legal entities will need review and most likely simplification. In those instances where centralization of capital with the lead company is not possible (e.g. mutual affiliations, regulatory requirements), the pool percentage should follow the capital position of all participants (including the lead company). Even companies that have significantly simplified their corporate structure can tie their remaining legal entities together with a common-sense pooling agreement that supports their operating strategy.

Key benefits

  • Diversification of underwriting results and earnings by legal entity: Pooling enables a larger spread of risk, allowing for less variable earnings and more predictable dividend streams by legal entity. For 0% net retention structures, including 100% quota share, the lead company enjoys the same diversification.
  • Improvement in capital position or financial strength ratings: If this is not the case already, the companies will be rated on a pooled (p) or reinsured (r) grouped basis, reflecting their combined financial strength. Additionally, this increase in financial size and diversification can improve the A.M. Best capital adequacy ratio (BCAR).
  • More efficient capital management: Companies can better centrally manage capital while retaining minimum required capital in pool/quota share participants and allocating premiums based on surplus capacity. This can help insurers manage premium to surplus ratios. Pooling and quota share also provide more efficient access to total capital by centralizing capital and avoiding dividend traps in subsidiaries.
  • Operational efficiencies: Pooling integrates various businesses’ finance and back-office operations, can provide momentum for more standardized and centralized reporting functions and can reduce frictional costs associated with the record-to-report function. Some potential efficiencies include: fewer intercompany agreements; lower audit fees from increased materiality thresholds and a combined statutory audit; consolidated regulatory exam; a more streamlined investment management function; and simplified reporting requirements (for 0% net retention agreements).
  • Marketing and branding: Some companies have been able to go to market as a group entity (particularly by affiliations of mutuals), which carries a larger financial size category (FSC). FSC is particularly beneficial for mid-size companies trying to gain market share in the broker market for commercial lines.

Challenges

While insurers operate within similar structures and against similar pressures, every company is different. There are a few common challenges we have encountered with our clients while designing and implementing intercompany pooling and affiliate reinsurance:

  • Disparate organizational groups, processes, and technologies: Affiliate reinsurance requires results from potentially disparate processes that may have different timing and data quality. Recording pooling entries may prove especially difficult for companies on multiple general ledgers. For the close, the combined pool is only as strong as its weakest link. This will be especially evident with subsidiaries that may have a streamlined close process but are dependent on other participants to close their books. We have seen companies undertake significant close process improvements to operate efficiently in a pooling agreement. This can be somewhat alleviated by structuring multiple affiliate quota share agreements in place of a pooling arrangement.
  • Additional requirements for generally labor intensive processes: It is not uncommon for insurers to have significant manual processes for calculating incurred but not reported losses (IBNR) or producing relevant disclosures such as Schedule P and F. Having distinctly different timing of key calculations and inputs can be a burden that all participants have to share.
  • Data management and quality issues: Companies that generally operate in silos, on separate ledgers, different chart of accounts or even make inconsistent use of chartfield values can find it more operationally difficult to execute pooling and difficult to leverage automated solutions.
  • Blending different businesses within results: Disparate operations and reporting groups that previously performed duties related to specific lines of business may find it difficult dealing with the new assumed business. For example, certain reporting disclosures required only for specific lines may become applicable to all participants in the pool.

Thinking “outside the box” to maximize value

Optimizing the benefits of affiliate reinsurance may result in arrangements that have previously been considered non-traditional, or at least lacking significant industry precedents. We encourage companies to maintain an open dialogue with regulators and rating agencies and believe that demonstrating a positive impact to operations, financial strength and overall policyholder benefits, outweighs lack of precedent.

  1. Centralizing capital and gross written business, where possible, is often the preferred structure for P&C companies: Zero-net-retention arrangements are a way to improve capital efficiency. While we have generally seen these structured as 100% quota share reinsurance, it may also be also possible to structure or modify a traditional pooling agreement to cede 100% of written premium to a lead company, with a 0% or minimal retrocession. Some key benefits we have seen include:
  • Capital management efficiencies – 0% net retention structures allow for minimum retained capital across the legal entities, centralizing on a lead company. This streamlines the capital management process and can simplify asset/liability management.
  • Financial reporting efficiencies – Centralizing net written business on a lead company can significantly reduce overall reporting requirements across the organization. Legal entities with 0% net business can discontinue certain laborious schedules (e.g. Schedule P Parts 2-4) and other reporting requirements for net business. Similarly, by retaining minimum capital on legal entities, investment disclosures can be simplified (e.g., fair value disclosures). Overall, we have seen companies reduce the statutory annual reporting pages by 50%, which can be compelling for larger organizations.

You should work with regulators to shift capital to the lead company in the most efficient way (usually at the inception of the pooling agreement).

  1. There are benefits for certain lines of business that have traditionally not been considered for pooling:
  • HMOsRequirements for HMOs to have legal entity domicile in each state in which they do business yields a corporate structure with a large number of thinly capitalized companies. Pooling can improve the capital efficiency, as well as reduce some other operational burdens. While this does not have significant industry precedent (within affiliated pools), we see no reason an agreement would be disallowed solely because an HMO is involved.
  • Significantly different businessRemoving preconceived constraints allows further expansion of potential opportunities and related benefits. We have assisted companies implementing agreements that have a mix of significantly different lines in the pool and have seen specialty insurance business (e.g. excess and surplus, program, crop, reinsurance, etc.) pooled with mainstream personal and commercial insurance. While there can be related challenges, if there are tangible benefits to diversification, then those challenges can be justified and overcome in the long run.
  1. The lead insurer does not have to be the parent company. In the same spirit of thinking outside the box for pool participants, we have found the lead company may not always be an obvious choice, particularly where all participants share percentage retention in the pool. The selection of the lead company should take into consideration the following:
  • Licensing – Requires licensing in all domiciled states of pool participants, all states of participants for retrocession and for all lines of business.
  • Domicile and regulatory environment – It is preferable to choose a lead company in a state of domicile where the organization has a favorable relationship with the regulator. Existing reinsurance arrangements or recent business restructurings are helpful. It is also critical to maintain open dialogue and communication with the regulator.
  • Capital size and efficiency – For larger companies or those with a more complex corporate structure, this can be a more difficult decision. Consider the efficiency of passing excess capital to an ultimate parent and avoid potential dividend traps. It is not always a parent company or the largest company that is best-suited to be the lead company.
  • Marketing and branding – For some companies, branding and marketing may become a factor in choosing the lead company. Some highly acquisitive companies may find certain lead companies inconsistent with their branding strategy.

Key considerations

We believe that intercompany pooling and quota share arrangements need to align with a company’s objectives and strategy and must be operationally feasible. It is often beneficial to have a third-party perspective that is not biased toward specific ingrained processes or behaviors. In particular:

  • Assess how well your people, process and technology can meet new demands.
  • Look beyond finance to consider various internal stakeholder perspectives, including actuarial, risk, investment, reinsurance and business leaders, as well as external constituents such as regulators, rating agencies and investors.
  • Because of the breadth of people, process and technology that will be affected, we recommend implementing a senior-level steering committee to oversee and drive design and implementation.

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In conclusion

There can be tangible benefits from re-evaluating or implementing intercompany pooling and affiliate reinsurance. This can further streamline the corporate structure, based on pre-determined objectives and supporting parameters. We encourage insurers to keep an open mind when designing pool parameters, including lead company selection. Maintaining an open dialogue with regulators and rating agencies is critical, particularly when setting a precedent with a particular pooling arrangement.

2 Shortcuts for Quantifying Risk

Most companies that take up risk management start out with subjective frequency-severity assessments of each of their primary risks. These values are then used to construct a heat map, and the risks that are farthest away from the zero point of the plot are judged to be of most concern.

This is a good way to jump-start a discussion of risks and to develop an initial process for prioritizing early risk management activities. But it should never be the end point for insurers. Insurers are in the risk business.  The two largest categories of risks for insurers — insurance and investment — are always traded directly for money.  Insurers must have a clear view of the dollar value of their risks. And with any reflection, insurance risk managers will identify that there is actually never a single pair of frequency and severity that can accurately represent their risks. Each of the major risks of an insurer has many, many possible pairs of frequency and severity.

For example, almost all insurers with exposure to natural catastrophes have access to analysis of their exposure to loss using commercial catastrophe models. These models produce loss amounts at a frequency of 1 in 10, 1 in 20, 1 in 100, 1 in 200, 1 in 500, 1 in 1000 and any frequency in between. There is not a single one of these frequency severity pairs that by itself defines catastrophe risk for that insurer.

Once an insurer moves to recognizing that all of its risks have this characteristic, it can now take advantage of one of the most useful tools for portraying the risks of the enterprise, the risk profile. For a risk profile, each risk is portrayed according to the possible loss at a single frequency. One common value is a 1 in 100 frequency. In Europe, all insurers are focused by Solvency II regulations on the 1-in-200 loss. Ultimately, an insurer will want to develop a robust model like the catastrophe model for each of its risks to support the development of the risk profile. But before spending all of that money, there are two possible shortcuts that are available to rated insurers that will cost little to no additional money.

SRQ Stress Tests

In 2008, AM Best started asking each rated insurer to talk about its top five risks.

Then, in 2011, in the new ERM section to the supplemental rating questionnaire, Best asked insurers to identify the potential impact of the largest threat for six risk types. For many years, AM Best has calculated its estimate of the capital needed by insurers for losses in five categories and eventually added an adjustment for a sixth — natural catastrophe risk.

Risk profile is one of the primary areas of focus for good ERM programs and is closely related to these questions and calculations. Risk profile is a view of all the main risks of an insurer that allows management and other audiences the chance to compare the size of the various risks on a relative basis. Often, when insurers view their risk profile for the first time, they find that their profile is not exactly what they expected. As they look at their risk profile in successive periods, they find that changes to their risk profile end up being key strategic discussions. The insurers that have been looking at their risk profile for quite some time find the discussion with AM Best and others about their top risks to be a process of simplifying the detailed conversations that they have had internally instead of stretching to find something to say that plagues other insurers. The difference is usually obvious to the experienced listener from the rating agency.

Risk Profile From the SRQ Stress Tests

Most insurers will say that insurance (or underwriting) risk is the most important risk of the company. The chart below, showing information about the risk profile averaged for 31 insurers, paints a very different story. On average, underwriting risk was 24% of the risk profile and market risk was 30%. Twenty of the 31 companies had a higher value for market risk than underwriting risk. For those 20 insurers, this exercise in viewing their risk profile shows that management and the board should be giving equal or even higher amounts of attention to their investment risks.

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Stress tests are a good way for insurers to get started with looking at their risk profile. The six AM Best categories can be used to allow for comparisons with studies, or the company can use its own categories to make the risk profile line up with the main concerns of its strategic planning discussions. Be careful. Make sure that you check the results from the AM Best SRQ stress tests to make sure that you are not ignoring any major risks. To be fully effective, the risk profile needs to include all of the company’s risks. For 20 of these 31 insurers, that may mean acknowledging that they have more equity risk than underwriting risk – and planning accordingly.

Risk Profile From the BCAR Formula

The chart below portrays the risk profiles of a different group of 12 insurers. These risk profiles were determined using the AM Best BCAR formula without analyst adjustments. For this group of companies on this basis, premium risk is the largest single category. And while there are again six risk categories, they are a somewhat different list. The risk category of underwriting from the SRQ is here split into three categories of premium, reserve and nat cat. Together, those three categories represent more than 60% of the risk profile of this group of insurers. Operational, liquidity and strategic risks that make up 39% of the SRQ average risk profile are missing here. Reinsurer credit risk is shown here to be a major risk category, with 17% of the risk. Combined investment and reinsurer credit is only 7% of total risk in the SRQ risk profile.

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Why are the two risk profiles so different in their views about insurance and investment risks? This author would guess that insurers are more confident of their ability to manage insurance risks, so their estimate of that risk estimated in the stress tests is for less severe losses than the AM Best view reflected in the BCAR formula. And the opposite is true for investment, particularly equity risk. AM Best’s BCAR formula for equity risk is for only a 15% loss, while most insurers who have a stock portfolio had just in 2008 experienced 30% to 40% losses. So insurers are evaluating their investment risk as being much higher than AM Best believes.

Neither set seems to be the complete answer. From looking at these two groups, it makes sense to consider using nine or more categories: premiums, reserves, nat cat, reinsurer credit, bond credit, equities, operational, strategic and liquidity risk. Insurers with multiple large insurance lines may want to add several splits to the premium and reserve categories.

Using Risk Profile for Strategic Planning and Board Discussions

Risk profile can be the focus for bringing enterprise risk into the company’s strategic discussions. The planning process would start with a review of the expected risk profile at the start of the year and look at the impact on risk profile of any major proposed actions as a part of the evaluation of those plans. Each major plan can be discussed regarding whether it increases concentration of risks for the insurer or if it is expected to increase diversification. The risk profile can then be a major communication tool for bringing major management decisions and proposals to the board and to other outside audiences. Each time the risk profile is presented, management can provide explanations of the causes of each significant change in the profile, whether it be from management decisions and actions or because of major changes in the environment.

Risk Profile and Risk Appetite

Once an insurer has a repeatable process in place for portraying enterprise risk as a risk profile, this risk profile can be linked to the risk appetite. The pie charts above focus attention on the relative size of the main types of risks of the insurer. The bar chart below features the sum of the risks. Here the target line represents the expected sum of all of the risks, while the maximum is an aggregate risk limit based upon the risk appetite.

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In the example above, the insurer has a target for risk at 90% of a standard (in this case, the standard is for a 400% RBC level; i.e. the target is to have RBC ratio of 440%). The plan is for risk at a level that produces a 480% RBC level, and the maximum tolerance is for risk that would produce a 360% RBC. The 2014 actual risk taking has the insurer at a 420 RBC level, which is above the target but significantly below their maximum. After reviewing the 2014 actual results, management made plans for 2015 that would come in just at the 440% RBC target. That review of the 2014 actual included consideration of the increase in profits associated with the additional risk. When management made the adjustment to reach target for 2015, its first consideration was to reduce less profitable activities. Management was able to make adjustments that significantly improve return for risk taking at a fully utilized level of operation.