Why reinsurers make unpopular exclusion decisions
Leading reinsurance brands such as Hanover Re, Munich Re and Swiss Re have come in for sweeping and often unfair criticism recently, as the insurance industry and insureds interrogate some of the steps reinsurers are taking to ensure the long-term sustainability of the global reinsurance market.
The extent of the post-COVID losses fresh in mind, and faced with soaring natural catastrophe losses, reinsurers are placing both emerging and historic risks under the microscope to reassess their exposures, and re-think insurability.
Rather than criticise, it may be time for all stakeholders to accept that insurance and reinsurance cover must ‘change’ in step with the global risk landscape. The good news is that most local insurance professionals appreciate the role that reinsurers play in picking up the tab for large losses.
A safety net for major catastrophes
“Global reinsurers’ consistent risk management, financial stability and client proximity make them a much sought after, trusted business partner to conventional insurers; [this is particularly relevant] as South Africa deals with the potential impact of national grid failure [not to mention] how load-shedding affects our portfolios, across all lines of business, from commercial to personal lines,” said Christelle Colman CEO and Founder of AMI Underwriters, in her role as MC for InsureTalk32.
A national electricity grid failure represents a type of financial Armageddon for the insurance sector. This risk, coupled with the pre-emptive grid failure exclusions introduced by reinsurers, was the backdrop for Munich Re’s participation as presenter and sponsor of the May 2023 non-life insurance focused InsureTalk webinar. The reinsurer took to the virtual podium to discuss ‘building financial resilience [and] how reinsurance concepts are used to manage insurer volatility’.
Paballo Makupu, Manager: Reinsurance Solutions at Munich Re said her interest in the topic was ‘piqued’ by the phenomenon of volatility in insurer profit and loss (P&L) accounts, especially during periods of hardening reinsurance rates. “[It is necessary to] investigate volatility within the insurance space, or more specifically, how underwriting margins are impacted by volatility, and how reinsurance can assist in managing same,” she said.
Some basic definitions, to start…
A discussion on a technical topic always starts with some basic definitions. Reinsurance, per the Glossary in Everything you need to know about non-life insurance in South Africa, is described as: A form of insurance that is purchased by an insurance company, referred to as the ceding company, from one or more reinsurance companies, either directly or through a broker, as a means of risk management. “The main purpose of reinsurance is for an insurer to ‘lock in’ some reinsurance recoveries [for] when it suffers a large loss,” Makupu said, before commenting on some of the other benefits associated with putting reinsurance covers in place. “The capital that an insurer is required to hold is net of risk mitigation; since reinsurance is a source of risk mitigation [it serves to] reduces an insurer’s capital requirement and [can] results in improvements in an insurer’s solvency levels,” she said.
It turns out there are three main themes relevant to the volatility of insurer’s P&L accounts, including: that investors have become more critical of insurers for missing profit targets; that reinsurance is increasingly used as a form of earnings protection; and that reinsurance is seen as crucial in reducing volatility in an insurer’s underwriting result. With the first point in mind, Makupu reminded the audience that it was often difficult for insurers to accommodate the needs of their diverse stakeholder groups.
Three stand-out insured loss events
Local non-life insurance professionals need not be reminded about the volatile nature of the domestic risk landscape. Over the past three years, the local industry has responded to the 2020-2021 COVID-19 pandemic; the July 2021 ‘civil commotion’ that affected areas of Gauteng and KwaZulu-Natal (KZN); and the devastating April 2022 KZN floods.
These stand-out insured loss events were in addition to countless large loss events occurring domestically and globally each year, as the frequency and severity of natural catastrophe losses continue to spiral higher. At the same time, insurers had to contend with inflation, rising incidences of insurance fraud; and changes in reporting standards, to name a few. For example, the new IFRS standards introduced P&L reporting challenges to insurers. Armed with this background we can consider how insurer’s calculate their P&L, and how reinsurance can be used to improve P&L outcomes.
The calculation starts with an underwriting result, which is in turn derived from four main inputs: premiums less the sum of incurred claims; acquisition costs; and operating expenses. Adding an insurer’s investment income to the underwriting result yields the insurer’s net profit before tax, and subtracting tax from that total gives you the insurer’s post-tax profit. Reinsurance can improve an insurer’s P&L result by reducing the incurred claims through reinsurance recoveries, but also serves as an important tool to manage an insurer’s reserving risks.
“The main need for reinsurance [is to] reduce an insurer’s capital requirement and improving its solvency level [as well as] disaster management from a catastrophe point,” Makupu said. Smart utilisation of reinsurance solutions also helps insurers to increase their risk capacity, so they can write more policies with reinsurance than without. The simplest reinsurance solutions are the so-called ‘traditional’ proportional or non-proportional type of solutions. In the former, the insurer and reinsurer split the premium and losses on a proportional basis, say 50:50 or 60:40. “A proportional structure reduces the amount that an insurer needs to pay and reduces its volatility in absolute amounts,” she said.
Introducing layers, limits and priority
A non-proportional structure is more technical, and features terms such as ‘priority’ and ‘limits’ and may feature several ‘layers’ between the priority and limit. In broad brushstrokes, the insurer retains losses below the priority, and the reinsurer picks up the losses above the priority. Peak losses presented by major catastrophe events can thus be significantly reduced in a non-proportional structure. “Insurers need to understand that you are not necessarily seeing these peak losses each year; and there are some expenses and premiums that you need to pay,” Makupu said.
PS, at this point, the writer wished he could include the diagrams that accompanied the presentation, but alas… What can be stated is that proportional reinsurance solutions work for insurers that want to reduce the absolute loss amount, whereas non-proportional solutions insulate insurers from peak losses. In practice, an insurer sits down with its reinsurance partners to determine an optimal reinsurance solution that aligns with the insurer’s objectives, which include disaster risk management; business growth and expansion; earnings smoothing and stability of returns; and solvency capital relief, to name a few.
Finding suitable structured solutions
“An insurer might approach us and mention that they would like to manage P&L volatility within a certain range,” concluded Makupu. “Or they might approach us for a structured solution [in which case we might suggest a] combined multi-year type of solution that speaks to both proportional and non-proportional needs”. The writer’s parting observation is that reinsurance solutions are tailormade to an insurer’s needs. Insurers that want to smooth their underwriting results, for whatever reason, will be able to structure a reinsurance solution to achieve same.
Writer’s thoughts:
Today’s article considers some of the ‘big picture’ reasons for insurer and reinsurer underwriting decisions. Is it possible to ‘sell’ your clients on cover exclusions, reduced cover or higher premiums in the name of a sustainable insurance industry? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
