Reinsurance Multi-year capital relief features@theactuary.com
REINSURANCE
UNCOVERED Can we learn from Solvency II to unlock the hidden value of reinsurance for long-tail business? Victoria Jenkins and Jessica Leong report
Reinsurance on a long-tail business such as casualty provides lasting capital benefits until the complete run-off of the underlying business. It reduces not only underwriting risk but also the future reserve risk for that book of business. Yet how many companies are truly considering this multi-year capital relief in their reinsurance decision-making? Compared with the current individual capital assessment (ICA) regime, Solvency II’s one-year risk horizon has the potential to draw attention away from multi-year risk. The complexity of creating a comprehensive multi-year capital model means that many companies are not focusing on the multi-year risk of long-tail business when considering their reinsurance strategy. Reinsurance strategy decisions are often evaluated by assessing the change in economic value between the current reinsurance programme and alternative
Graph 1: Straightforward way of assessing the multi-year capital benefit of reinsurance or reserve value added
Step 1: Project reduction in reserve risk capital until run-off Step 2: Calculate reduced capital cost Step 3: Discount back at risk-free rate
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options. We define the economic value of a strategy as the difference between the expected return and the cost of servicing the risk capital required to support the strategy: economic value = net underwriting profit – (net capital required x cost of capital).
Long-term view The difference between the economic value of the current strategy and an alternative strategy is the economic value added (EVA). A positive EVA can be thought of as an improvement on the current strategy. Typically, EVA only considers the capital savings over a one-year horizon – that is, the economic value formula looks at the reduction in the required underwriting risk capital over the next year only. For short-tail property classes of business, this is often a reasonable assumption, especially for catastrophe business. From an economic capital modeling perspective, as soon as the most recent accident or underwriting year has elapsed, the risk transforms from contributing to underwriting risk and drops into the reserve risk bucket until it has completely run off. So, for casualty reinsurance, we believe that the economic value calculation should include the multi-year reduction in future reserve risk that the reinsurance provides. We call this reserve value added (RVA). If RVA is ignored, suboptimal strategies could be chosen. Calculating RVA exactly requires a complex, multi-year capital model and reserve risk model. However, we advocate a simpler approach. While Solvency II can potentially draw attention away from the multi-year view through its one-year horizon, its approach to calculating the risk margin can provide a sound framework for calculating RVA since it measures the cost of the capital required to back a book of liabilities over the entire run-off. We can use this to determine the savings in capital cost from ceding a portion of the liabilities.
June 2013 • THE ACTUARY 27 www.theactuary.com
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