Closing the Divide

Over the past two decades, a transformation has occurred in how Canadian property insurers measure, manage and mitigate first-party threats. The use of models has created an objective framework for evaluating risk, establishing risk tolerance and addressing exceedance with dovetailed reinsurance strategies that reduces downside risk to targeted levels.

In the face of advances in casualty catastrophe modelling and the greater use of enterprise risk management (ERM), liability insurers are on the verge of a similar transformation in risk management, reinsurance focus and strategy.

Until recently, there has been a widening divide between the framework that supports property versus casualty exposures.

While third-party vendor models are embedded within most companies’ property portfolio optimization, peak risk mitigation strategies and ERM frameworks, there is no universally accepted equivalent for liability.

The lack of a defined risk management framework is a consequence of the inherent complexity of casualty business, driven by latent exposures and continually evolving risk, coupled with the (correct) assertion that extreme property losses present the greater threat to liquidity and capital over a 12-month time horizon.

These fundamental differences in casualty threats present a palpable challenge to liability insurers in quantifying the threats and setting the appropriate strategy for management and mitigation. Consequently, focus has tended to be on expected versus actual loss ratios, which while invaluable as a performance metric, provides no meaningful insight to the real potential downside risk – whether to earnings or, more importantly, to capital.

The complexity of casualty and the fact this business exhibits more challenging exposure management dynamics relative to property is no longer sufficient justification for not developing robust risk management framework and advancements are being made quickly. Improvements in liability modelling, the greater adoption, and integration, of ERM, and external stakeholder interest in understanding how liability tail risks are evaluated and quantified are all converging to stimulate a heightened focus on tail risk and the extreme threats to liability insurers.

With some larger insurance companies now reporting their liability event return periods, momentum will inevitably grow, with shareholders, analysts and other stakeholders increasingly expecting greater levels of risk management transparency across the industry.

CHANGES IN (RE)INSURANCE STRATEGY

Historically, liability lines have tended to be protected from results volatility by independent profit centres. Today, by embracing a group-level approach, liability insurers are matching reinsurance with corporate appetite for risk.

Motivated by a need to increase margin in a competitive market where growth is hard to come by, these strategies are enabled by – and, in turn, are enabling – larger and more robust balance sheets. This interplay is manifesting itself in reinsurance programs, spanning most or even all liability lines, either within a geographic territory (for example, North America) or globally, sometimes with increased retentions, but always conveying economic efficiency.

Companies are reclaiming the economic value of diversification and either choosing greater self-finance (of expected loss) or seeking those benefits to be factored into their reinsurance pricing through the adoption of consolidated casualty reinsurance strategies.

Directionally, companies are less concerned about managing a single loss at the business unit level, the impact of which might be readily contained net within a broad, diverse portfolio. As such, focus is shifting to the management of accumulations or concentrations of exposures and potential or expected losses.

The role of external reinsurance is required to finance those bigger and more severe threats to earnings or capital (as company risk appetite dictates).

LARGE LOSS WOUNDS, SYSTEMIC LOSSES KILL

Liability risks are dynamic and rapidly evolving threats that may not necessarily be constrained in space or time, and globalization means liability risks are no longer localized or within a single territory. Compounding these difficulties are evolving legal and regulatory systems, changing social attitudes and the rate of product development.

In many industries, innovation is ingrained as a constant, where every new development can become a new risk, and technology is continually becoming more and more ingrained in every aspect of daily life.

As an example, while data breach and accompanying loss of records at organizations such as Home Depot and Target have generated many headlines and significant insurance losses, these single-risk exposures are, indeed, manageable within the context of traditional reinsurance. The greater threat could arguably be from a co-ordinated attack, not just on a single company, but on an entire industry; not merely breaching privacy information, but bringing down transactional systems and cutting business supply chains.

As insurers build scale through cross- selling or through industry or segment specialization, overtly working to become a “go-to market” in select trades or industries, these companies begin to accumulate larger pools of homogenous risk.

RESPONSE TO SYSTEMIC LOSS

There are a number of traditional reinsurance solutions that provide an element of protection for accumulation risk. The value of embedded catastrophe cover within excess of loss and proportional per risk reinsurance is too regularly eroded by loss caps or other limitations that limit severe tail risk protection. It is the resulting net per risk accumulations that represent the greater challenge for companies to measure, manage and mitigate.

Aggregate protections, while often considered to provide the gold standard for mitigating downside risk, tend to be priced accordingly and have historically lacked cross-cycle resilience in

liability lines. Other mechanisms, such as occurrence reinsurance, provide effective cover for disasters such as the Lac-Mégantic tragedy, which are limited in space and time.

However, neither is designed to respond to the more complex and potentially more corrosive losses that emerge once exposure has been amassed across many accident years. The inherent latency in losses occurring trigger also means counterparty risk at the tail needs consideration.

The complexity surrounding the definition of a liability occurrence, which may be systemic in nature, means these exposures are commonly overlooked by occurrence programs. While a named-perils approach to defining coverage for property reinsurance is tried and tested, the unforeseen nature of liability exposures require an alternative approach.

While most companies will address known liability exposure through underwriting discipline and portfolio management, it is the unknown exposures that represent the greatest challenge.

To answer the industry’s growing desire to obtain a systemic hedge against group liability risk, Willis Re recently developed a product to respond to complex and unforeseen exposures that cannot be confined to named perils. It recognizes the ability for liability events to emerge after exposures exist on multiple accident years and for losses to transcend theoretical lines of business or territorial boundaries.

Structured as a facility to streamline the process of building reinsurance to address complex tail exposures, all facility reinsurers have agreed to a template wording. Limits up to $400 million per program are available to companies, although the limit available to any one client recognizes that not all companies require the same level of downside protection.

The facility preserves a client’s right to control its reinsurers and is supported by a syndicated panel of reinsurers that can offer the depth of market required to provide cross-cycle resilience and efficient price discovery.

Conclusively, insurers have been afforded the benefit of effective reinsurance for event-based threats in the property market that have been responsive, resilient and efficient.

Focus now shifts to the equivalent on liability business.

Indeed, a recent report from A.M. Best suggests that over the 35 years from 1977 to 2013, almost half of all financial impairments have been driven by casualty threats versus less than 10% from property-based risk. An effective hedge for such threats is invaluable and long overdue.