Reinsurance & ART Week 6

Course Structure Week 1: Introduction/Background Week 2: Traditional Reinsurance (Proportional) Week 3: Traditional Reinsurance (Non-Proportional) Week 4: Implementing Reinsurance Contracts & Reinsurance Operation and Strategy Week 5: Insurability and Climate Change & Exam I Week 6: Corporate Risk Management (Self-Insurance /Captives) Week 7: Ratemaking & Estimating the XL Premium & Regulation t Week 8: Risk Swaps/ILWs Week 9: Finite Reinsurance Week 10: Background to Derivatives (Risk Mgmt / Hedging/Weather Deriv) Week 11: Catastrophe Bonds Week 12: Review

Insurability and Climate Change Climate Risk ◦ Health Issues ◦ Agriculture ◦ Energy Increased frequency and severity of hurricanes and flooding ◦ “Of the 10 most expensive natural catastrophes over the past 56 years, six occurred in 2004 and 2005.” Charpentier, 2008, P.94.

Insurability and Climate Change Climate change will stretch the limits of insurability. ◦ Difficult to estimate an accurate premium… ………….difficult to diversify…. …to charge an affordable premium… Legal insurability, Actuarial insurability, Economic insurability.

Insurability and Climate Change “the private insurance industry feels that it cannot continue to provide coverage against hurricanes and earthquakes as it has done in the past without opening itself up to the possibility of insolvency….” Kleindorfer and Kunreuther, 1999

Insurability and Climate Change Solutions Traditional Reinsurance Alternative Reinsurance Financial Reinsurance The Government

Reading Charpentier, A., 2008, Insurability of Climate Risks, The Geneva Papers, 33,

Reinsurance Learning Objective ◦ Reasons why risk transfer matters, ◦ Corporate Risk Management: Theory and Practice, ◦ Self-Insurance/Captives. Corporate risk management can be broken down into: ◦ Risk avoidance, risk reduction, risk transfer and risk retention. 8

Alternative Risk Transfer Introduction Definition: The use of risk transfer mechanisms other than traditional insurance and reinsurance. The rise of ART ◦ 1. Equity ‘bear’ market. ◦ 2. Rise in expected claims costs. ◦ 3. Financial markets. Reasons why risk transfer matters. ◦ Managerial self-interest, ◦ Cost of financial distress, ◦ Capital market imperfections, ◦ Non-linearity of taxes. 9

Risk Transfer Managerial self-interest ◦ Managers have limited ability to diversify their own personal wealth position, ◦ Stability preferred to volatility. Risk of bankruptcy (financial distress) ◦ Increased cost of finance, ◦ Relationship with client, ◦ Departure of key personnel, ◦ Stock price. Capital market imperfections ◦ Cost of volatility is the forgone investment in each period that the firm is forced to seek external funds, ◦ Equity & debt issuance have associated costs. 10

Risk Transfer Nonlinear tax functions ◦ Income ‘smoothing’ reduces the effective tax rate. ◦ Tax functions facing firms are convex  Higher levels of earnings lead to higher rates of marginal taxation  Above a certain threshold, earnings pass through several marginal rates 11

Risk Transfer Insurers are in the risk business ◦ they assume various kinds of actuarial and financial risks ◦ risks may be eliminated or mitigated  reinsurance, pricing and product design Many risks are superfluous to the institution’s business purpose. 12

Corporate Risk Management Example BP – exploration, extraction, refinement, and distribution of oil and gas : Profits were $2bn per year, Assets of $50bn (1991). Adopted a strategy of purchasing less coverage against very large losses. Local managers purchased coverage for losses up to $10m. Losses between $10m and $500m are generally not insured.

Corporate Risk Management Example Reasons for change in strategy: (1)BP had paid over $1.15bn in premiums during the prior decade and had received $250m in claim payments; (2)Coverage disputes with insurers were more likely for losses of this magnitude; (3)The impact of losses of this size on firm value was small, given BP’s size; and (4)Insurers have no advantage compared to BP in providing safety and loss control services.

Corporate Risk Management Example For losses above $500m BP doesn’t purchase insurance: (1)Insurance market capacity to provide coverage to losses this large is limited; (2)The ability to deduct losses from taxable income reduces demand for coverage, and (3)A loss of this size due, for example, to destruction of a major oil rig could increase the price of oil, thus mitigating the loss.

The ART Market Risk Carriers Self insurance/captives Capital Markets Risk Products Finite risk (re)insurance Contingent capital Weather derivatives (e.g. Hurricane Call Options), Securitisation / ILS. 16

The ART Market Risk Carriers ‘In 2001, the size of the global ART carrier market was estimated at about $88billion’ SwissRe, sigma No. 1/2003 Self-insurance / captives are the major carrier. Self-insurance makes up 75% of the total alternative market. 17

The ART Market Risk Carriers Self-insurance Definition: Establishing reserves for future losses instead of purchasing insurance. In reality: No Insurance. Accounting mechanism that moves expense from one period to another, i.e. the management of earnings. 18

The ART Market Risk Carriers Captives An insurance/reinsurance company owned by a corporation or group of companies which are not active in the insurance business themselves. Rapid growth during the hard markets of 1970’s and 1980’s. Currently over 5,000 captives globally. Approximately 150 captives registered in Ireland. 19

Captives Who uses a captive? ◦ Over 70% of Fortune 500 companies. ◦ Many private companies. ◦ Associations or affinity groups. Uses of a captive ◦ Can write all classes of insurance benefits, incl. life, employee benefits. ◦ Most common covers are property and casualty. ◦ Act as insurer or reinsurer. ◦ Corporate or customer risk.

Captives Benefits (1) ◦ Minimise external premium spend ◦ Participate in underwriting performance ◦ Stabilises effects of insurance market cycle ◦ Improved cash flow ◦ New revenue stream ◦ Fiscal benefits

Captives Benefits (2) ◦ Broad cover, flexible design ◦ Create additional capacity ◦ Management buy in ◦ Discipline of running a regulated entity ◦ Direct access to reinsurance markets

Captives Locations ◦ Many on and offshore jurisdictions ◦ Legislation and regulation ◦ Developed financial infrastructure Bermuda, Cayman Islands, Isle of Man, Ireland, Vermont, Malta, Gibraltar, Guernsey, Luxembourg, Singapore, Hawaii.

Captives Candidates ◦ Companies with predictable attritional losses. ◦ Companies with better than market average loss experience. ◦ Companies with poor loss experience but dedicated to improved risk management. ◦ Companies with uninsured risks. ◦ Global programmes consolidation. ◦ Companies able to sell insurance products to their customers.