Session 5 Risk Mitigation and Diversification

Session 5Risk Mitigation and Diversification Regional Training Seminar IAIS-ASSAL San Salvador, El Salvador, 22-25 November 2010 Takao Miyamoto, IAIS Secretariat

Agenda • Reinsurance Products • Types • Features • Risks Associated with Reinsurance • Credit • Liquidity • Operational & Legal • Supervisory Viewpoints • Objectives • Strategies & Monitoring Mechanism • New Forms of Risk Transfer 1

Proportional Retained or Ceded to another reinsurer Ceded Retained Retention ratio 20% Limit 1,000 Retention amount 200 Limit 1,000 2

Comparison 3

Non-Proportional • Protect from large loss & accumulated loss • Supplement proportional reinsurance • Excess of loss • Cover aggregate loss per risk or event beyond certain threshold • Stop loss • Cover accumulated loss for certain period beyond certain threshold 4

Comparison 5

Risk Transformation • Reinsurance transforms risk • To mutual advantage of both parties • Parties assume different types of risk • Reinsurance contracts do not remove insurer’s underlying legal liability to policyholders • Insurer • Transfer underwriting (insurance) risk • Create other risks (e.g. credit, liquidity, operational, legal) 7

Credit Risk Credit (counterparty) • Settlement by reinsurer may not be received due to failure of reinsurer, while insurer remains liable to fund all valid claims under insurance contracts • Examine financial strength & payment records of reinsurer • Establish security criteria • Set exposure limit to single reinsurer or group of related reinsurers • Diversify • Examine resilience of program under stressed situations 8

Liquidity Risk Liquidity • Series of large claims may give rise to cash flow difficulties if there were delays in settlement by reinsurers or in providing proof of loss to reinsurers by insurer • Line of credit from banks • Clauses that allow for accelerated payment from reinsurers in event of large claims • Use of collateral, deposit account 9

Operational & Legal Risk Operational & Legal • Administrative arrangement may create problems • Contracts may not always respond in ways insurer expects • Adequate administration & IT system capabilities • Effective tracking of aggregate claims which may give rise to recovery under reinsurance program • Timely reporting • Ensure to collect receivables • Clear contract language & commonly used contractual terms • Long standing nature of personal & corporate relationship 10

Supervisory Regime • Supervisors should have access to all information about reinsurance program • Regular reporting system • Upon request • Supervisory recognition • International & cross-border nature of reinsurance • Reduce duplication of efforts, compliance costs & regulatory arbitrage • Unilateral, bilateral & multilateral approaches • IAIS can be hub of information & cooperation • Reinsurance Subcommittee • Global Reinsurance Market Report (GRMR) (http://www.iaisweb.org/index.cfm?pageID=538) 12

Objectives • Supervisors should understand commercial rationale behind reinsurance program as part of assessment Capacity • Provide flexibility in size, types & volumes of business insurer can reasonably undertake • Allow to enter, expand or withdraw within short period Financing • Work as alternative to increasing insurer’s capitalisation 13

Objectives Stability • Limit fluctuations in underwriting results & financial performance Protection • Provide protection against potential large accumulation of losses from catastrophic events (e.g. earthquake) Expertise • Gain technical, underwriting & claims assistance 14

Strategies • Insurer should have reinsurance strategies • Appropriate to scale, nature & complexity of business • Part of wider underwriting and risk & capital management strategies • Examples • Risk appetite (e.g. gross limit, net retention) • Level of diversification • Consideration of credit risk • Comparative cost of capital • Liquidity positions • Views on future market & economic trends • Underwriting forecast 15

Monitoring Mechanism • Insurer should establish systems & controls to ensure implementation & compliance of strategies • Approval of reinsurance program • Regular reviews of performance • Management information • Examples • Link to capital assessment • Security criteria of reinsurers • Exposure limit to single reinsurer or group of related reinsurers • Criteria for purchasing facultative coverage • Legal issues • Timely & complete reporting due to/from reinsurer 16

New Forms of Risk Transfer • Example: Cat (catastrophe) bond • Use capacity of capital market (from insurer’s perspective) • Diversification due to low correlation with other asset classes (from investor’s perspective) 18 (Source) Munich Re “Insurance-linked securities (ILS) market update”

Additional Viewpoints • Similar to reinsurance in many aspects but some special features • e.g. use of wide variety of arrangement, including creation of Special Purpose Vehicles (SPEs) • Fully funded • Ownership structure, ranking of payments, stress test on cash flows, use of derivatives • Bankruptcy remote • Legal opinion. disclosure (e.g. prospectus, offering circular, memorandum) • Basis risk • Trigger under SPE arrangement can be different from that for underlying liabilities • e.g. Parametric (driven by objectively measurable events) • e.g. Modelled (driven by outcome of modelled loss) 19

¡Muchas gracias! www.iaisweb.org takao.miyamoto@bis.org 20

Session 5 Risk Mitigation and Diversification