Amid an unprecedented confluence of headwinds, solutions for achieving capital optimization
The Covid-19 pandemic clearly presents significant challenges to insurers, but it is also becoming increasingly clear that (re)insurers are likely entering a far more favorable underwriting environment.
This article was written by Ed Hochberg, head of global risk solutions at Guy Carpenter
After years of relative stability brought about by strong capitalization, the landscape for the sector has undeniably changed, with pressure on the asset side of balance sheets coinciding with high natural catastrophe losses, shrinking reserve cushions and social inflation.
Because of the resulting pressure on the sector’s balance sheet, industry observers are predicting hard market conditions, the extent of which we have not witnessed since the early 2000s. These market dynamics are leading companies to think about how to manage capital in order maximize opportunities. As such, many carriers are looking to reduce the amount of capital dedicated to supporting loss reserves for prior years; by doing so, this capital can be redeployed to more attractive current and future underwriting opportunities.
“Reinsurance products that protect loss reserves unlock this capital, and by leveraging their existing balance sheets, carriers can essentially access capital in a relatively cost-effective way”
With the development of sophisticated capital models by carriers, rating agencies and regulators, it is now relatively straightforward to measure and quantify the capital supporting prior years’ underwriting (reserving risk). For many, if not most, property and casualty insurance companies, the capital held against reserving risk is a material portion of the overall required capital. Reinsurance products that protect loss reserves unlock this capital, and by leveraging their existing balance sheets, carriers can essentially access capital in a relatively cost-effective way. These solutions may also be attractive in environments where it is difficult or impractical to access any other forms of capital, for example, mutual companies.
Reserve protection covers take several forms:
Adverse development covers (ADCs), which are essentially excess of loss covers attaching at or above carried reserve levels;
Loss portfolio transfers, which generally attach at first dollar of carried reserves;
Legacy covers, which carriers utilize to exit discontinued lines of business, and in some cases (particularly outside of the United States), these transactions involve legal finality; and
Reinsurance-to-close transactions for Lloyd’s syndicates.
These products offer a wide array of benefits, including:
Capital relief: Reserve covers reduce the amount of capital backing reserves under most economic, rating agency, or regulatory capital frameworks.
Protection: The risk that the subject reserves develop adversely is transferred to the assuming entity.
Exit of lines/classes of business: There is an active run-off market that is designed to take on discontinued business and the related reserves, including the ongoing servicing of claims. As noted above, in some cases, these transactions will involve legal finality. By exiting lines or classes of business, the transferring carrier can redeploy capital, and management time and attention (and expense), associated with the discontinued businesses.
”There are many misconceptions about these transactions. Probably the most prevalent one is that there is no value in them if a carrier has adequate or redundant loss reserves”
The form of transaction used and its exact features will be a function of the particular objectives of the carrier, the nature of the underlying business, and other factors that will be specific to the situation.
There are many misconceptions about these transactions. Probably the most prevalent one is that there is no value in them if a carrier has adequate or redundant loss reserves. Even if a carrier is thought to have very strong reserves, it is still likely to have a significant portion of its required capital supporting loss reserves. Because of the risk of exogenous shocks, as well as inherent uncertainties in loss reserving, there is always some risk of reserves developing adversely, even where companies reserve relatively conservatively.
“Any “stigma” that may have been associated with these deals is quickly becoming outdated”
Therefore, loss reserve protection will provide capital relief for such companies. Additionally, some believe the purchase of loss reserving protection indicates some sort of problem or issue with loss reserving. Because it is now relatively easy to quantify and unlock capital, more and more companies have entered into one or more loss reserve protection transactions; any “stigma” that may have been associated with these deals is quickly becoming outdated.
To offer an example, a publicly listed carrier with approximately $5bn of loss reserves expects significant new underwriting opportunities in the coming years. While the company has regularly had favourable development, in its capital models it has calculated that about half of its required capital supports a loss reserve base (approximately $1bn of loss reserve risk after diversification). The insurer purchases an ADC providing $500mn of limit over an attachment point of $5.5 billion. By reducing reserving risk by the amount of the limit, the ADC effectively provides capital, which would be expected to stay in place for several years; the cost of this capital is well below that of external capital without using debt capacity or diluting existing shareholders. The company is now positioned to take advantage of an improving underwriting environment.
To conclude, loss reserve protection covers can provide a great deal of value to carriers. In what is expected to be a significantly improved underwriting environment post-Covid-19, companies can leverage their existing balance sheets before (or in addition to) seeking external capital.