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The Challenges With Catastrophe Bonds

Catastrophe bonds are an increasingly important form of risk transfer for insurers. Cat bonds are a peculiarity of the U.S. reinsurance market, where about 125 to 200 natural disasters occur a year. They were first sold in the mid-1990s after Hurricane Andrew and the Northridge earthquake highlighted the need for a new form of risk transfer. The cat bond market has been growing steadily for the past 10 years, and more than $25 billion in catastrophe bond and insurance-linked securities are currently outstanding, according to Artemis.

Many insurers have moved away from managing their ceded reinsurance program with spreadsheets, which are time-consuming and error-prone, in light of current regulatory and internal demands. More carriers have installed — or are planning to install — a dedicated ceded reinsurance system that provides better controls and audit trails.

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Besides enabling reinsurance managers to keep senior management informed, a system helps carriers comply with the recent Risk Management and Own Risk and Solvency Assessment Model Act (RMORSA). It also generates Schedule F and statutory reporting, an otherwise onerous job. And technology prevents claims leakage (reinsurance claims that fell through the cracks).

Cat bonds add a layer of complexity. The cat bond premium is a “coupon” the insurer pays to the bond buyer. There are many potential losses behind each bond, and the potentially huge recovery amounts to as much as hundreds of millions of dollars for some insurers. Other complexities include a priority deductible, an hours clause, lines of business reinsured or excluded and attachment criteria to automatically identify subject catastrophe amounts. Without technology, tracking all this can be overwhelming.

The ceded reinsurance system can also be used to manage cat bond premiums. From a system perspective, it’s not terribly different. The same analytical split (per line of business and per insurance company in the group) applies to bonds just as it does to reinsurance treaties. With a little tweaking, a solid ceded reinsurance system should be able to handle cat treaties and bonds equally well.

While ceded premium management for cat bonds shouldn’t be difficult, claims present bigger challenges, especially when trying to automatically calculate the ultimate net loss (UNL) because additional factors and rules are often used to determine it.

For instance, it may be necessary to apply a growth-allowance factor, determine the number of policies in force when the catastrophe occurs and calculate growth-limitation factors. This allows the calculation of ceded recoveries in case of a catastrophe. Additionally, the calculation of UNL may be specific for each cat bond — and even for each corresponding peril.

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Automating all this isn’t necessary because few events trigger those complexities. Once a manual workaround incorporating the audit trail and justification of the subject amounts is done, the reinsurance system can handle the remaining calculations. While it’s not necessary to fully automate all steps to calculate the UNL, it is still better to handle the whole process with an integrated information system than with multiple spreadsheets that are unwieldy and labor-intensive.

Without the right technology, managing cat bonds is daunting. With automation, they can be managed far more effectively.

The Need to Automate Reinsurance Programs

“Do you know where your children are?” That was a popular catchphrase in a TV public service announcement.

Do you know where your reinsurance program is? Many senior executives at insurers can’t say for sure.

Many insurers find it a struggle to document their ceded reinsurance program (the risk they have transferred to a reinsurer) in a way that’s acceptable to regulators—and senior management—because they have not automated management of ceded reinsurance policies, data and claims. According to a recent survey, only 14% of primary carriers have a reinsurance system. Most insurers still use spreadsheets or other manual methods to keep track of their reinsurance contracts and claims.

The NAIC Risk Management and Own Risk and Solvency Assessment Model Act (RMORSA) became effective in January 2015, and many states have adopted this model legislation. RMORSA requires insurers to have a systematic way of identifying, assessing and managing risk, and everything related to reinsurance is certainly part of it. Under it, insurers are required to submit an annual summary report to their primary regulator. A key part of complying with RMORSA, and other regulations, will be documenting reinsurance coverage in detail.

It is possible to comply with RMORSA without a true reinsurance system. But it’s a difficult, time-consuming process that doesn’t guarantee good results. Using a spreadsheet and other manual methods to track contracts and claims doesn’t give you everything you need in one place for regulatory filings. For instance, an insurer might not being able to identify out-of-compliance policies. This can occur when a reinsurer requires one or more exclusions in the policies it reinsures. If the insurer issues the policies without the exclusions, the policies are out of compliance, and the reinsurer may deny liability when there’s a claim.

But complying isn’t just a bureaucratic exercise. The RMORSA process also helps insurers get a clearer picture of their risks—and what could be more important for a company whose business is managing risk?

Implementing a modern reinsurance management system enables complete automation, controls and audit trails. It will generate Schedule F and statutory reporting at a click of a button. This, in turn, will reduce Schedule F penalties to the bare minimum.

Managing Risk

Regulatory compliance is hardly the only reason to use dedicated software to track ceded reinsurance. Intricate reinsurance contracts and special pool arrangements, numerous policies and arrays of transactions create a massive risk of having unintended exposures. Inability to ensure that each insured risk has the appropriate reinsurance program associated with it is a recipe for disaster.

An insurer must track and integrate many reinsurance processes. They include cession treaties and facultatives, claims and events, policy management, technical accounting (billing), bordereaux/statements, internal retrocession, assumed and retrocession operations, financial accounting, accounts payable, accounts receivable, regulatory reporting, statistical reports (such as triangulation per line of business, type of contract and region) and business intelligence.

With fragmented solutions such as spreadsheets and manual processes, things often fall between the cracks because there are so many reinsurance-related items to manage. Financial information for trends, profitability analysis and exposures becomes unreliable. Automating processes can reduce the chances of missing something important to almost zero.

Stanching Claims Leakage

One of the biggest problems is claims leakage. How do you know when a reinsurer owes your company money? Answering that question is not as straightforward as it seems, given the complexity of many different types of reinsurance contracts.

For instance, after implementing a reinsurance solution, a European insurer detected more than $1 million of overlooked claims. (You can’t file a claim if you don’t know you have one.) It contacted its reinsurer, which paid promptly.

The situation for insurers that don’t automate will only get worse. Many of the experienced reinsurance administrators have retired or will be retiring in the next few years, and there are few in the pipeline coming up. With reinsurance becoming ever more complicated, the only feasible answer for insurers is a comprehensive reinsurance system that puts everything in one place. The effort and cost are well worth the benefits in staff productivity, risk reduction, better claims tracking and improved regulatory compliance—to avoid RMORSA remorse and a host of other problems.