Shifting gears by shifting risk

Risk is our business. As insurers and reinsurers, it is our ability to measure it, manage it, absorb it and transfer it that makes our business valuable to society, and to our shareholders.

Risk can also be a strategic asset. Advances in the use of risk transfer through reinsurance as a means to efficiently manage capital management are allowing insurers to free up capital for growth.

Define the absolute
Growth is often an absolute for investors. The question is how to achieve it, and whether the best strategy is simple organic growth, expanding the footprint into new territories.

Other options are mergers and acquisitions or simply shifting business out of an under-performing segment and into more profitable lines of business domestically.

If expansion is needed, so is capital, and here insurers can make use of the risk they have taken on. They can, for example, monetise future profits of a long-term book of business through a so-called value in force monetisation.

Generally, the technique transfers the underlying risk through a reinsurance agreement, and the expected future profits are paid out in the form of a reinsurance commission.

When the best option is to sell the business altogether, a stumbling block for a potential investor may be that they do not have the knowledge or capability to manage the underlying risk – even if other parts of the assets could be of interest.

In such a case, building a risk transfer into the sale can be used to offload the risk portion to a reinsurer and hence dress the bride to make the sale more attractive to the equity partner.

Getting volatility out

Volatility is the enemy of any long-term investor, and at the same time, it is a simple fact of life in the risk business.

The techniques for managing large peak-volatility scenarios are well-known: reinsurance and the capital markets in the form of insurance-linked securities being the most popular. These solutions work well for well understood events that occur at a given point in time, such as natural catastrophes or pandemics.

However, larger than expected losses need not happen with a bang; social trends, legal norms and financial markets undergo long term change and these can creep into insurance portfolios.

The long-term impact of smoking trends is probably the most famous example. Adverse developments can affect reserves and lead to increased claim amounts and losses having to be paid out earlier than expected. Because insurers need to set reserves against their expected losses, adverse development can become a huge headache and create substantial risks.

A potential solution here is to combine an adverse development cover, which limits the increase of the reserves, with a loss portfolio transfer, which takes care of the investment and timing risk.

Accumulation

In recent years, the accumulation issue has grown in line with an increasingly globalised world. The catastrophic losses incurred by the Thai floods in 2010 are prime examples of how global supply chains can trigger massive business interruption claims.

Here, risk transfer is often not the only answer. Tools are needed to develop accumulation scenarios, assess maximum potential losses in portfolios, and monitor accumulation processes and forward-looking models. Once the full picture is understood, it is possible for risks to be diversified and pooled together within a risk-transfer portfolio that can be placed with the reinsurer. This holistic approach keeps the portfolio attractive and the reinsurance rates low.

The above examples only scratch the surface of the interplay between risk and efficient capital management. It is an area where solutions go beyond out-of-the-box risk transfer and require strategic vision and expertise to implement.

However, the door is open for insurers to do more with risk and to employ it as strategic asset.