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Are you a switched on buyer?
Corporate insurance buyers who can understand and replicate their insurers’ and reinsurers’ rating processes stand to get the best results, says Raj Ahuja of EMB.
 We have heard a lot in the trade press about relations between risk managers and their insurers, and how buyers can make their programs more attractive in the eyes of underwriters. Much of the comment has rightly concentrated on issues such as demonstrably high quality risk management procedures and accurate exposure information. Important as these are, there has been relatively little comment on another and often critical aspect of negotiation: the way insurers rate their risks.
There are two reasons why understanding this aspect of the business is beneficial to commercial buyers. Firstly, it provides useful insight into underwriters’ thought processes. Secondly, applying the same processes to their own organisations will enable them to understand better their risk profiles and exposures and to identify the most cost-effective steps to acquire greater stability. This is especially desirable at a time when insurance–buying strategies are changing, usually with substantially increased retentions.
These benefits apply whether or not there is a captive involved, and to negotiations with reinsurers as well as insurers. Such considerations are especially relevant now that deductibles are at historically high levels and that, whether or not you agree with them, the weather modellers are urging us to take a pessimistic view of future patterns.
Property is not, however, the only important class of insurance to consider in this context. Liability (especially EL) and Motor are two other areas where losses and premiums have escalated, partly because of legislative developments and inflation.
The methods used by insurers and by reinsurers to rate large corporate risks have gone through a transformation in the past five years in response to rigorous methodologies, supported by rating and simulation software and also to pressure exerted by security analysts and shareholders.
Until the end of the 90s, most underwriters’ rating strategies could be summarised, admittedly with some degree of oversimplification, by the following formula:
Old Price Allow for insured’s recent loss experience Allow for market trends
=
New Price |
This ‘suck it and see’ approach goes a long way towards explaining why so many risk carriers once hemorrhaged losses by under-pricing their products. Put simply, this approach is out-of-date and only a few insurers cling to it. Yet it remains embedded in the mindset of many buyers, contributing to the misunderstandings that occur around the negotiation table.
The professional approach to underwriting begins with the re/insurers creating ERM (Enterprise Risk Management) models of their businesses. This practice is similar in principle, though not identical to the ERM often practised within corporates; both share an holistic approach to risk.
The exercise involves identifying and quantifying all the risks inherent in the re/insurance company (including those that are not underwriting or investment-related). It is then possible to create stochastic simulation models that enable you to feed in any number of possible real-life scenarios and measure their potential financial consequences. Managers can use this information to determine accurate underwriting guidelines for all their classes, consistent with their return-on-capital targets. (The modelling has many wider strategic advantages as well, but they are outside the article’s scope.)
As you would expect, modelling is heavily data-driven. Acquiring accurate and meaningful data, both historic and predictive, is a large part of the challenge as is adjusting this data to make it relevant. The answers are only as good as the quality and consistency of the input, and there are now powerful software products to assist.
What does this mean for corporate insurance buyers? Your personal relationships, although still important, are just one part of the jigsaw. Underwriters simply do not have the room for manouvre that they once had; your terms will have to comply with the rating structure as set out by the re/insurer and their need for a satisfactory long-term return on capital.
Of course, the ability to demonstrate good risk management and internal controls will have a bearing, but re/insurers generally believe they have already responded in these areas; they will require evidence of further and material changes. Another way to help your cause is to provide sufficient detailed and reliable data in the format that the models require.
The vaguer the information, the more the underwriter is likely to take a cautious view: in other words, to increase your premiums. Many insurance buyers believe they already provide the necessary data, but the underwriter often sees it differently. You would be well advised to consult your broker and/or underwriter about what they require long before you begin the next renewal process.
And that is one reason why large corporates should consider creating risk models similar to those of their re/insurers. Doing so will enable them to anticipate how their underwriters will respond to a particular package and what incentives or concessions might produce the most favorable response. You will get an early indication of what is causing the premium to be so high allowing you time to provide solutions.
A more important implication for buyers is that they are being forced to accept much higher deductibles. In the Property/Business Interruption classes, many corporates have started to retain huge amounts of non-catastrophic risk, either directly or through their captives. This relates to both Property and Casualty. Whilst this may be a sign of good and confident management, it increases the inherent uncertainty and generates a lack of predictability for the P&L. That is a second advantage to creating your own risk model; it will enable you to manage and predict your residual (uninsured) risk effectively.
Let’s turn now from the theoretical to the specific: a retailer, in Exhibit 1, with outlets across North America and physical assets worth slightly more than $1.25 billion, employing around 5,000 staff and running some 300 cars and commercial vehicles. Reinsurance is arranged via a captive and, after the 2005 storms, only kicks in at $1 million for all perils for Property/Business Interruption. All other classes have each and every loss deductibles of $200,000.
The risk manager has in the past sought to estimate likely losses to within a margin for error of $0.5 million, but the new structure makes this a considerably more difficult challenge. He creates a model to help him to quantify his risk and give him a clearer idea of his retained exposures. A key output is shown in Exhibit 2 where the buyers can really consider the degree of risk retained. The higher percentiles prompt a review of risk carried on the balance sheet and further, more complex, risk structures are needed.
This is the sort of thing that a growing number of corporates are doing, especially in North America and Europe, now that it has become a lot simpler. The secret is to choose a model or modelling software that allows maximum flexibility and to start with a relatively limited and straightforward project. Once successfully completed and the lessons learnt, you can then progress to something more ambitious and wide-ranging. ‘Fit for purpose’ is always a key consideration.
One of the outcomes of this particular model is that, although the different classes may diversify risk to some extent, there is also a tendency (in the extreme) for them to move together. In other words, if one class gets out of control, there is small chance that the others will go in the same direction with pronounced effects on the P&L and balance sheet.
Overall, the risk manager decides that the probability of missing his margin for error is too high with an unacceptable level of volatility. After running a series of scenarios through the model, he decides that the most cost-effective reduction strategy would be to buy an Aggregate stop-loss policy around the net retained losses. Ironically, he does so through a subsidiary of the same reinsurer whose higher deductibles have forced him down this road in the first place. The outcome is that he can be confident of predicting his net retained losses to within $1 million. It is a reasonable compromise, and enables him to deliver a level of stability that his board will accept.
More effective re/insurance buying is by no means the only benefit of the exercise. It can be a central tool, for example, in devising a wider mitigation strategy. Nonetheless, since insurance is clearly the risk manager’s responsibility in most large organisations, this is most likely to provide the most immediate incentive for creating a model.
It can also improve relationships with your underwriters. This kind of modelling exercise is not confrontational, it is about greater professionalism. It helps you to understand their thinking and can foster mutual respect. If the spread of this kind of practice is one outcome of the market changes since WTC and Katrina, then some good will have emerged from them.
This article appeared in AIRMIC News in March 2007
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