Risk in Non-life Insurance Underwriting
Wayne Fisher
Introduction
This chapter addresses the risks inherent in non-life underwriting
from the perspective of the Risk Officer. It covers risk issues such
as mitigating unintended concentrations, evaluating correlations
between risks, ensuring an adequate underwriting infrastructure to
measure and manage exposures, and ensuring adequate data for
quantifying risk accumulations and measuring diversification. The
underwriting process itself is not addressed as that subject is amply
covered in underwriting texts.
Risks in Underwriting Individual accounts
A non-life insurance company is in the business of assuming risk from
individuals and businesses. Underwriting is the discipline of
understanding and evaluating which risks to intentionally assume.
Minimizing unintended underwriting risk and the risk to the enterprise
from unintended risk accumulations is generally a responsibility
shared between Underwriting and Risk Management ("RM"); both
disciplines are critical.
The underwriting function needs to ensure that a robust infrastructure
is in place so when individual accounts are underwritten the
underwriter has: adequate information on the risk, such that the
exposures can be reasonably known and understood, the skills and
experience required to analyze the risk, and the ability and incentive
to design coverage and price the account properly. Underwriting
authority needs to be granted based on skills and experience and not
on managerial hierarchical level. Referral authorities need to be in
place, as well as effective auditing to ensure compliance with
delegated authorities, in order to minimize opportunities for "rogue"
activities. The underwriting infrastructure also needs to provide
training and oversight such that applicable laws, statutes,
regulations, filings and so forth are rigorously followed. Adherence
to filed rates, forms and similar measures is intended to reduce the
opportunity for money laundering, terrorism funding, and so forth, and
to ensure that customers are treated fairly.
An underwriting infrastructure also needs to be in place to allow for
the meaningful capture of data on the risks underwritten. This is
necessary to monitor concentrations, meet any regulatory reporting
requirements and have the ability to manage the underwriting of
individual accounts to remain within agreed limits on aggregate
concentrations.
Concentration Risk from Insurance Activities
The insurance and reinsurance mechanisms work most effectively when
dealing with risks that are not correlated with one another. By this
we mean that the likelihood of a claim occurring is not impacted by
the fact that another claim has occurred. In cases where risks are
correlated with one another, the (re)insurer must be cognizant of
potential concentration risk.
Concentration risk arises in multiple forms and is the area where RM
generally has the greatest involvement. Concentration risk arises
from systemic risks, stacking risk, and clash risks. A particular
form of systemic risk comes from natural and man-made catastrophic
exposure.
Systemic risk is the accumulation of losses triggered by a single
event or cause, affecting one or more industry segments rather than a
single risk. Asbestos is the classic example of a systemic risk
affecting multiple industries and policyholders, lines of business and
policy years. RM and Underwriting need to ensure processes are in
place to identify similar potential risks and to monitor and
effectively control accumulations.
A current risk with potential systemic impact is nanotechnology.
Underwriting and RM need to determine the economic risks, which lines
of business might be exposed to loss (ie, products liability, workers
compensation), the likely effectiveness of coverage restrictions in
policy wordings, the probability of different economic risk outcomes
and the aggregate limit to expose the enterprise.
Stacking is another aspect of concentration risk. Stacking refers to
the accumulation of net (after reinsurance) retentions within the same
line of business on the same insured. Here the risk arises, for
example, from multiple business units providing coverage for the same
policyholder plus participation in a reinsurance program from a
policyholder's reinsurance captive. Procedures such as a name and
location clearance system are typical ways to prevent such an
unintended accumulation.
Clash is a similar concentration risk that occurs when one or more
business units insure more than one line of business for the same
policyholder which could be affected by the same claim or incident.
This could lead to a higher than intended aggregate loss. Reasonable
foreseeability and a large dose of common sense, together with an
effective name clearance system and an agreed exposure limit are the
keys for Underwriting and RM in managing these exposures.
Exposure to systemic risk arises from both natural and man-made
catastrophic events. Monitoring and managing risk accumulations
requires detailed data (see below), models and an underwriting
infrastructure that spans all lines of business and all business units
that write policies in potentially exposed locations. Critical from a
RM perspective is the ability to monitor accumulations across lines of
business and locations and to intervene when aggregate limit
boundaries are breached. Mitigation actions might include simply
abstaining from additional underwriting commitments (or nonrenewing
existing commitments upon expiry) or purchasing additional treaty or
facultative reinsurance for peak exposures. The critical element is
having the infrastructure to identify unintended accumulations across
multiple business units and all lines of business.
The concentration risk of natural catastrophes arises primarily from
exposure to earthquakes, floods and windstorms. Property damage and
business interruption accumulations are typically modeled by using
sophisticated commercial modeling tools (RMS, AIR, EQECAT, etc.).
Systemic risk also includes additional lines of business, such as
workers compensation, employers liability, accident and health, group
life, marine, and automobile physical damage. These exposures may not
be coded to location in the same detail as property policies, nor be
subject to the same modeling capability. As such, RM needs to be
comfortable that processes are in place and effective to identify peak
property exposures through name and location clearance systems in
order to allow for identification of significant exposures to
non-property lines of business at the same location.
Man-made catastrophic events can similarly impact all lines of
business. This category includes events ranging from terrorism,
primarily, to a train accident involving toxic chemicals. Terrorism
exposures are generally divided into two categories: conventional
attacks (conventional bomb, aircraft used as a missile) and
non-conventional (nuclear, chemical, biological, radiological "NCBR"
e.g. a "dirty bomb"). Property and business interruption policies may
or may not include coverage for a terrorist act or coverage for NCBR.
Policies covering worker compensation or employers liability, by their
nature, may provide coverage for all such events. From a RM
perspective, it's important that data be captured identifying policies
with NCBR coverage. It is also vital that the same infrastructure and
modeling capability for monitoring and managing accumulations noted
for natural catastrophes be in place for man-made catastrophic
exposures.
Stress Scenarios
Stress scenarios are especially necessary for determining aggregate
limit boundaries for natural and man-made catastrophic events and
guiding decisions on purchasing reinsurance protections. For example,
in addition to considering the results generated from the modeling
tools, the ERM framework for Lloyd's includes consideration of
specific Realistic Disaster Scenarios as a test of exposures under
extraordinary circumstances.
Further, RM is uniquely positioned in many insurance organizations to
consider the interaction of risks from different organizational silos
in stress scenarios. Very low probability events, like a 1 in 250 year
windstorm or earthquake, a significant terrorism incident, or a
pandemic will require RM to have considered not just the underwriting
risk but to have incorporated the potential impact on the investment
portfolio, liquidity, reinsurance recoverables, and business
continuity both from a holding company and individual subsidiary legal
entities level. Mitigation actions may then involve internal or
commercial reinsurance, standby credit, and/or similar arrangements to
balance the potential exposures and financial stress the organization
faces.
Concentration Risk from Credit-Related Exposures
Another aspect of concentration risk arises from multiple
financial-related exposures to an individual policyholder. A
significant event, such as a fraud or severe downturn in
profitability, might lead to losses from a D&O policy, surety and
fiduciary coverages, and/or financial guarantees, plus losses on any
debt or equity investments, securities lending, reinsurance
recoverable from a captive, and exposure as a counterparty to a
derivative transaction. In addition, third-party liability and/or
retrospectively rated insurance programs may generate exposure due to
large deductibles, retrospective premium adjustments or other credit
risk.
From a RM perspective, tools to monitor and evaluate peak exposures
bridging insurance commitments and financial holdings need to be in
place, as well as assurance that assessments of the creditworthiness
of the policyholder are effective and guiding collateral negotiations.
Correlations between the various insurance and financial exposures
under stress scenarios need to be determined with limits set
reflecting both underwriting and credit rating considerations.
Data Capture
Accurate, thorough, relevant, detailed data capture is key to
measuring, modeling and managing the risks of unintended exposure
accumulations. RM needs to ensure that adequate auditing is in place
to allow reliance on the data collected. Similarly, RM needs to be
comfortable that underwriting has the processes in place to monitor
and manage individual account underwriting across multiple business
units, policyholders and lines of business to stay within agreed risk
limits. Name clearance systems, allowing each underwriter
participating on a policyholder's program to see all the commitments
to that policyholder, are an effective tool in this regard, as are
systems to monitor accumulations by class and line of business.
Detailed data capture is especially critical for monitoring property
accumulations for catastrophic exposure to both natural and man-made
events. Granular data including the policyholder's type of business,
number of employees, construction type and age, values insured,
business interruption coverage and limits, and so forth, for each
precise location (street address, latitude and longitude) are
critical. Experience from many insurers examining losses from Katrina
has shown that modeled catastrophic exposures were understated. One
reason for this was incomplete data capture of insured locations.
Risk needs to be comfortable that data capture is complete and audited
as necessary for the modeled accumulations to be meaningful.
RM must also be forward thinking about data capture. It is not
sufficient to think about capturing data for risks that are current
and obvious, but to also think about where the emerging risks are
arising and what data is necessary to assess these risks.
Reinsurance Risk
Reinsurance is a widely used and valuable tool for mitigating peak
risks on both individual accounts and portfolios. Inherent in
reinsurance are several risks of concern to the Risk Officer.
First and foremost RM must be attentive that the reinsurance purchased
is actually providing the appropriate coverage to mitigate the peak
risks. In this regard, there needs to be strong communication between
underwriting and the reinsurance buying function to ensure that
underwriters are aware of the provisions of the reinsurance treaties
being purchased. In particular, awareness of exclusions or special
acceptance criteria is vital. On the facultative side, underwriters
or facultative buyers must be trained to have coverage afforded by the
facultative reinsurance be concurrent with the terms of the underlying
policy.
The insurance enterprise is exposed to various risks when purchasing
reinsurance. These include: Credit Risk, Regulatory Risk, Operational
Risk (including Non-Concurrency (mentioned above) Lack of Contract
Certainty, and Accounting/Tax Risk) and potentially Reputational Risk.
Credit risk has numerous aspects which must be managed. The starting
point is the assessment of the credit worthiness of the reinsurer.
This process generally leads to an "approved list" of acceptable
reinsurers and a limit on the aggregate credit exposure to an
individual reinsurer which is linked to its credit rating.
Reinsurance may be purchased locally on a facultative basis by
underwriters for individual accounts with peak exposures and also in
multiple business offices on a portfolio, or treaty, basis. RM needs
to ensure that adequate controls are in place so accumulations by
reinsurer are monitored with actions taken to mitigate peak exposures.
Accounting risk arises as accounting for reinsurance transactions can
be complex. Reinsurance transactions need to have risk transfer
characteristics in totality support insurance/reinsurance accounting
(to be included in financial results as reinsurance) and these
characteristics need to be appropriately analyzed and documented. In
particular, the accounting must consider all aspects of the agreement,
including any written or verbal side agreements
Also of concern is ensuring that reinsurance transactions are not
structured to obfuscate the true financial results of the company.
Overly complex transactions and certain "circular" transactions can
lead to accounting difficulties. For example, policyholders may have
captive insurers or reinsurers involved in their risk management
program. Sometimes the structure of these transaction becomes
extremely complicated with the captive being the insurer, a reinsurer
and/or a retrocessionaire. With many moving parts, it becomes
difficult to assess the true nature of the transactions and to record
all of the necessary accounting entries in an accurate and timely
manner. This operational risk is one on which the Risk Officer's
organization must focus, ensuring that appropriate controls are in
place to mitigate the risk.
For both commercial reinsurance and captive arrangements, training and
oversight need to be emphasized and sufficiently robust to ensure that
there is a significant degree of risk transfer (underwriting and
timing risk), any fees are reasonable, no side agreements, verbal or
written, the financial records of both parties reflect the transaction
the same way, and similar measures. The Risk Officer needs to be
comfortable that procedures are in place so all such arrangements
receive appropriate oversight and monitoring.
Facultative reinsurance purchased locally to protect individual
policies and treaty reinsurance has significant measures of
operational risk. These include delays in agreeing policy wording and
a resulting lack of contract certainty, non-concurrent terms and a
simple failure to execute as intended. The Risk Officer needs to
ensure that the operational risk measures developed enterprise-wide
extend to the placement of reinsurance.
Alternative Risk Transfer
Large natural catastrophe losses in 2004 and 2005 and enhancements to
catastrophe accumulation models have increased the demand for
reinsurance and retrocessional protections. In turn, this demand has
led to increased utilization of alternative risk transfer mechanisms
to supplement the traditional reinsurance markets. In particular
catastrophe bonds, industry loss warranty protections, hedge funds and
so-called "side-cars" have grown in popularity. These facilities
provide much needed, fully collateralized capacity to insurers and
reinsurers but may include basis risk which must be included in risk
capital determinations.
Catastrophe bonds typically involve a special purpose vehicle which
provides protection to the insurer/reinsurer. This is done through
traditional, indemnity reinsurance coverage based on the insurer's
ultimate net loss, or, more typically, a recovery is determined based
on a derivative (or parametric) measure of the loss. For example, one
based on the industry loss or the modeled loss from an event. The
SPV, in turn, develops its capitalization through the issuance of
bonds to investors. In the event the reinsurance is triggered, the
bondholder will not receive all or any of their principle at maturity.
The parametric coverage approach, while more attractive to the
investor in the catastrophe bonds as the investor doesn't have to
underwrite the individual company, includes basis risk the Risk
Officer needs to evaluate. That is, it is possible that the buyer
could have a loss to which the coverage does not respond.
Industry loss warranty protections are structured similarly but the
protection triggers are typically based on relatively narrowly defined
risks and regions and a resulting aggregate industry loss. Industry
loss warranties are attractive to investors for simplicity but include
considerable basis risk for the insurer which needs to be evaluated.
Another alternative source of reinsurance capacity is reinsurance
provided by thinly capitalized reinsurers backed by hedge funds.
These reinsurers provide reinsurance on a fully collateralized basis,
meaning that the full limit of the reinsurance is collateralized at
the inception of the contract. Risks with these vehicles include
operational risks, risks pertaining to the collateral and failure to
satisfy statutory requirements. The RM should also be aware that
these vehicles typically do not include the reinstatement coverage
available in traditional reinsurance.
Finally, so-called "side cars" are special purpose reinsurance
vehicles similar to those vehicles that facilitate Catastrophe Bonds.
These vehicles are funded by both debt and equity and typically
provide quota share reinsurance to the sponsor (re)insurer. The SPV
has limited capital resources and this limitation acts to cap the
quota share coverage provided by the facility. This structure has the
potential of "tail risk", which is the risk that the sidecar cannot
meet its reinsurance obligations to the cedant in an extreme event.
RM should consider and be aware that many alternative sources of
reinsurance are transacted with capital that may be more opportunistic
than traditional reinsurance. This capital may disappear if terms and
conditions are not ideal.
Post –Event Large Loss Reviews
Insight into the effectiveness of the myriad individual account
underwriting processes, concentration monitoring and management, data
collection and operational risk can be gained through a systematic
review of large losses in a collaborative effort between underwriting
and RM. Incidents that lead to insured losses happen. That's why
people and companies buy insurance. But insight into adherence to
relevant guidelines when the risk was underwritten and the impact the
risk has had on the various concentration management measures can
provide Underwriting and RM with valuable information.
Emerging Risks
Emerging risks are exposures which may develop or already exist. They
are difficult to quantify, may have a high loss potential and are
marked by a high degree of uncertainty. Risks involving emerging
technologies or environmental changes require identification,
assessment, monitoring and mitigation. Examples of such emerging
risks would include nanotechnology, pandemics, genetically modified
foods, changes in weather patterns, and so forth. RM needs to ensure
that Underwriting identifies coverage triggers, lines of business
potentially exposed, limits, accumulation potential across lines of
business and policy years, reinsurance applicability and monitors
developments broadly in the insurance, healthcare and legal arenas.
Mitigation actions need to be agreed with Underwriting regarding
coverage, limit and volume restrictions, reinsurance protection and
monitoring of potential accumulations. RM is a key driver in
determining the importance of identifying emerging risks, designing
actions to contain unintended accumulations and monitoring that risk
measures are effectively in place.
Correlated Risk
Assessing the degree of correlation between lines of business and for
each line to other risk types is a critical requirement. It is
necessary to determine risk capital and optimize the mix by line,
limits exposed and volume in order to minimize required capital
through diversification. Relevant experience may well be very limited
for analyzing correlations, especially at the critical stress levels
most important to risk capital determinations. Hence, RM generally
needs to work closely with Underwriting to judgmentally assess and
agree the degree of correlation.
As an example, property and business interruption coverages may
generally be seen as having a very low correlation with casualty
coverages. An incident causing a loss may not typically affect both
coverages, exposure to inflation in loss costs in future years is far
less in property, reinsurance costs tend to have different trends, and
so forth. The actual situation is more subtle, however, for the more
extreme scenarios. A large factory explosion may lead to losses to
policies that protect workers and to liability if neighboring
buildings are damaged. Potential for a D&O exposure also exists if
the explosion was found to be the result of management negligence.
Similarly, one would expect a higher degree of correlation between D&O
exposure, surety, financial guarantees and the investment portfolio
under stress scenarios. Operational risk might be seen as more
strongly correlated with property exposures due to the complications
with monitoring aggregate catastrophe accumulations and placing
facultative reinsurance than casualty exposures. RM and Underwriting
need to ensure that adequate consideration is given to stress
scenarios intended to mirror the probabilities and correlations
underlying the risk capital calculations, especially as respects
individual subsidiary legal entities.
Risks in the Underwriting "Cycle"
Price levels in non-life insurance tend to move in multi-year cycles
as the result of varying levels of industry capital, economic outlook,
competition and similar considerations (see diagram below).
Theoretically, an actuarially correct price for each account can be
consistently determined based on desired ROE and anticipated loss
trends. Actual prices, terms and conditions will deviate from the
actuarial price based on marketplace conditions.
Increased risk results from a failure to systematically measure
deviations from the actuarial price and to fully recognize such
deviations in current financial results, particularly during times
when marketplace pricing is less than the actuarial price. RM needs
special attention that actual pricing, terms and conditions are
monitored and that loss reserves and current financial results reflect
deviations from actuarial pricing. Risk capital is required for
uncertainty in this measurement due to the increased risk of
understated loss reserves and added volatility as a consequence.
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