Casualty Risk: Playing Catch Up

casualty catch up

The complexity of casualty business and the fact that it exhibits more challenging dynamics relative to property catastrophe are no longer sufficient justification for not developing a robust risk management framework. While property risk management has evolved over three decades since the early days of catastrophe modelling, casualty is being compelled to catch up fast.  After all, shouldn’t casualty insurers benefit from the same access to information that property insurers have when facing decisions regarding purchasing reinsurance?
It is hard to remember a time when today’s exposure models were not available to support decision-making in all key areas of insurers’ short-tail property portfolios. Even Luddites would concede that the global insurance industry’s risk management framework for property threats is more robust and effective today.

Indeed, over the past 30 years the property catastrophe market has been transformed by the universal adoption of exposure-based vendor models to evaluate downside risk. The output from these models underpins modern risk management frameworks and is required to satisfy internal and external stakeholders that capital is concomitant with the level of risk assumed.

The Traditional Approach

In contrast, the global casualty market has not evolved in its use of exposure-based modelling. At present, the insurance industry generally focuses on loss ratio to support casualty risk management decision-making. However, this is a performance metric, not a downside risk one.

Some companies have incorporated realistic disaster scenarios (RDS) into their casualty risk management frameworks. Yet while RDS is a good step towards addressing downside risk, the challenges of relying on this approach are determining appropriate realistic scenarios and the methodology for quantifying the associated loss which, if inconsistent, could easily over or underestimate tail risk.

An RDS methodology also fails to quantify losses across the return period spectrum, creating a binary assumption of downside risk.

As another methodology, some companies also rely on factor-based formulae, such as volumes of premium or standard equations of reserve risk. However, this approach does not provide any insight into the individual exposures, classes, customer types and accumulations within industries that drive downside risk.

While property perils are understandably considered the greater liquidity threat, given the nature of the losses, the facts suggest a different hierarchy and warrant consideration.

A More Robust Approach?

Over the past 35 years, according to AM Best’s September 2014 Special Report on US Surplus Lines, catastrophe losses caused 7% of financial impairments while 47% were caused by deficient reserves.

This suggests that either risk management improvements, the use of third-party vendor models and general oversight in the property segment has reduced risk—or that “we” are looking in the wrong direction in terms of threats. Or perhaps both.

Given the dynamic nature of casualty risk compared to the more static nature of property threats, there are many difficulties and challenges associated with measuring casualty versus property perils.

Setting aside the impact of shifting tectonic plates, the relative pace of change in property business is glacial, even when including the effects of climate change. Casualty, on the other hand, is prone to myriad forces, all changing in real time at a local, regional and global level.

Over the past 35 years, catastrophe losses caused 7% of financial impairments while 47% were caused by deficient reserves

Changing legal and regulatory systems, increasing globalisation, social and technological developments and key economic factors all compound the difficulties of forecasting.

The complexity of casualty business and the fact that it exhibits more challenging dynamics relative to property catastrophe are no longer sufficient justification for not developing a robust risk management framework.

The greater adoption of enterprise risk management, the enhanced use of models in long-tail lines and greater demands from internal and external stakeholders have all converged in fuelling the need for underwriting organisations to set in motion a plan to advance how they measure and manage their casualty portfolios – and quickly.

While property risk management has evolved over three decades since the early days of catastrophe modelling, casualty will be compelled to catch up fast.

Not only do organisations seek improvements in their risk management process for the obvious reasons of improved decision-making, but external stakeholders are also turning their attention to the perceived deficiencies in casualty risk management.

Illustratively, AM Best’s recent Supplemental Rating Questionnaire is one example of a shift in thinking that heralds an accelerated and expanded interest from regulators, rating agencies and shareholders alike, all of whom are looking for companies to demonstrate how they quantify their casualty portfolios and subject them to prudent stress testing.

Measure, Manage, Mitigate – M³

Recognising the challenges that casualty writers face, a comprehensive process to guide organisations in constructing a comprehensive risk management framework is needed: insurers need to measure, manage and mitigate.

Only once risk is being accurately and consistently measured can organisations determine how much of it they wish to retain, whether in absolute terms, relative to capital and/or earnings and the return period spectrum.

Currently, if you were to ask insurers to quantify their casualty probable maximum loss, most would be somewhat bemused. They would seek to suggest that such a question was a property one. But to assert that quantification of severe risk has no role in casualty business is absurd.

Armed with data to measure risk, an attempt can be made to determine a risk appetite framework, which in casualty business is complicated by the inherent latency of a casualty account where losses can span numerous accident years.

To assert that quantification of severe risk has no role in casualty business is absurd

Establishing risk appetite from threats that manifest quickly over the time horizon of, say, a hurricane, is a world apart from making how much casualty risk to retain, given years or even decades of prior-year exposure and the potential of similar risk duration into the future.

Furthermore, condensing that into a “property cat style” risk tolerance statement equating loss to a percentage of quarterly earnings or as a percentage of capital is doable, but not uncomplicated.

Models of the Future

So far, few models exist to provide clients with the ability to measure their downside risk. Willis Re’s Entail model is one, providing casualty catastrophe event loss tables (ELTs) akin to those used to manage property portfolios.

Compounding the need for such models is the increased focus on casualty and on measuring downside risk at an enterprise level, which is leading to changes in the strategic focus around the purchase and use of reinsurance.

As the focus of risk shifts from a business unit level to the wider group, so the reinsurance strategies follow. This is leading to a greater willingness to move away from line of business silos and towards consolidated reinsurance programmes.

By consolidating group casualty exposures into single placements, companies are not only matching reinsurance with their appetites but are also explicitly reclaiming the economic value of scale and diversification in their reinsurance strategy.

While these shifts in focus create challenges of allocating cost and recoveries to business units, none are insurmountable and the economics are clearly compelling.

One area where scale does not help, of course, is systemic accumulations. These, by definition, are amplified by scale and fuel a heightened focus on systemic loss and how to mitigate against such threat scenarios.

Willis Re is tackling these challenges head-on, having developed a systemic casualty solution, Primo. This has been supported initially by over 20 of the leading casualty reinsurers, in a manifestation of the industry’s growing desire to obtain a systemic hedge against group risk.

Indeed, as scrutiny from organisational stakeholders – both internal and external – continues to grow, we are observing the beginning of a transformation in the risk management of casualty business that incorporates:

  • how to measure group-wide downside risk
  • how to articulate a group-wide risk tolerance strategy
  • how to optimise the net portfolio via a revamped retention and reinsurance strategy

In sum, casualty risk management is changing, and this in turn is changing the strategic focus of reinsurance and both the type and level of support that insurers require of their reinsurers.

To paraphrase those generals who at the beginning of the Great War surmised that the skirmish “would blow over by Christmas,” this change is far from over.

Perhaps the decision for practitioners is whether to resist or embrace that change. If that sounds rhetorical… it is.

 


 

This article was first published as part of the Summer 2015 edition of InsiderQuarterly – IQ – the global re/insurance industry’s only quarterly publication, which contains insightful interviews and thought-provoking features and analysis on the industry written by the team from The Insurance Insider.

 

About Andrew Newman

Andrew Newman is President and Global Head of Casualty at  Willis Re.…
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