Insurers are in the business of aggregating risk. This makes enterprise risk management (ERM) particularly important to insurers.
In addition, insurers have an incredibly flexible and powerful tool available for sculpting their risks: reinsurance.
ERM is a very new approach to risk that has been embraced by insurers just in the past 15 years. Reinsurance, on the other hand, has been around for almost as long as insurance. Do they work together? Can the new ERM process learn from the mature reinsurance approach?
The answers are yes and yes.
The insurer’s perspective
An insurer’s ERM process looks very much like the process of designing a reinsurance program. Both start with the articulation of risk appetite and tolerance – how much and what kind of risk does the insurer want to have (retain) at the end of the process (though the reinsurance world may not have used those particular terms until recently). The picture above shows how insurers look at risk from a variety of perspectives and choose from a variety of reinsurance tools to achieve their desired outcomes.
Because reinsurance purchasing is a familiar process, insurers seeking to establish an ERM framework can draw upon this experience to inform their ERM risk appetite and tolerance.
Management choices about reinsurance protection illustrate how much insurance risk the company is willing to retain from individual insureds, single events, lines of business, and annual underwriting results. ERM-related risk tolerances can be developed by extending the reinsurance thinking to other risks.
ERM thinking may also influence reinsurance decisions. For insurers with significant reinsurance purchases and a developing ERM program, the ERM thinking often spurs an evolution of reinsurance philosophy.
Taking an enterprise-wide view of the risk profile, companies often choose to consolidate historically separate purchases on similar risks – thereby taking advantage of diversification benefits and efficiencies of scale.
As they develop greater confidence in their selected risk appetites, insurers may decide to calibrate reinsurance structures to achieve better alignment with corporate strategy. And they may adjust the balance of retained risk among lines of business in light of temporary or longer term differences in risk adjusted returns.
Perspective of rating agencies and regulators
At the same time, outside bodies such as rating agencies and regulators have been urging that insurers take up ERM. They all agree that reinsurance is a crucial risk management tool, and will want to learn how well the reinsurance program fits with ERM goals.
It is not that the goal of rating agencies and regulators is to give insurers more work to do. Their interest lies in establishing the insurer’s resilience; and they recognize that no one can understand an insurance company’s risks better than the company itself. By asking insurers to explain and justify their own view of risk, these outside bodies can gain a much better understanding of how effectively the selected risk mitigation strategies – including reinsurance – support the company’s objectives.
The investment and insurance losses that major reinsurers experienced in 2001 served as a “wake-up call” to the industry. Since that time, reinsurers have increasingly sought to coordinate their risk acceptance and retrocession strategies through the lens of ERM.
For many reinsurers formed following 2001, ERM has been a fundamental part of their business strategy. While the 2008 financial crisis was an unprecedented shock to world markets, reinsurers have for the most part weathered that storm – and the ensuing economic challenges.
In recent years, prudent risk management is increasingly seen as a differentiator. For example, since 2013 Partner Re has disclosed risk limits for a dozen major risks along with their actual risk acceptance in their annual report. Other international reinsurers have followed suit.
It’s hard to know to what extent ERM drives reinsurer behavior, but as ERM has become further ingrained over the last several years, reinsurers have shown some different behaviors, even in the face of an extremely competitive marketplace as compared to prior decades. Catastrophic events have not created major dislocations in the market or, in general, threatened reinsurer solvency. Capacity has been generally available, and reinsurers are showing more discipline in avoiding over-concentration.
And, despite competitive pressure from alternative capital and the hardship of persistently low investment returns, analyst consensus places reinsurer return on equity expectations in 5% to 10% range, quite respectable in the current economic environment.
For more on this topic see our recorded webinar.
This post was co-written with Alice Underwood. Alice Underwood is an Executive Vice President with Willis Re and leads the Analytics team for Willis Re North America, encompassing actuarial, catastrophe modeling, financial and rating agency advisory, and ERM services. Alice holds a Bachelor of Science in mathematics from The University of Texas and a Ph.D. in mathematics from Princeton University.