What keeps reinsurers up at night?

So far, 2012 has been a quiet year for reinsurers. The lack of any substantial catastrophic events has allowed them to recover from last year’s onslaught of losses and return to profitability. The current calm has not, however, lulled them into a false sense of security.

Reinsurers spend a lot of time scanning the horizon for potential threats, and these can come from a variety of sources. We surveyed 12 companies to find out the risks that are keeping their top executives awake at night and which are at the top of their agendas.

Perhaps surprisingly, it is not catastrophic events that top their list of concerns: instead, it is regulation. The impending Solvency II regime remains a worry to many, it seems, and is proving onerous for reinsurers seeking compliance or equivalence. Their concerns range from logistical issues, such as staffing levels, to the overall structure of the regulation and the way it is being implemented.

The sovereign debt crisis in Europe is also piling pressure on reinsurers. The uncertainty is slowing economic growth not only on the continent, but across the world. This means both less business to go around as clients contract or consolidate and reduced investment returns because of low interest rates.

While well intentioned, this action is proving to be particularly damaging to reinsurers. Many have relied on investment returns, as opposed to underwriting profits, for many years. It is also a big concern for reinsurers with a lot of longtail business on their books, which worry whether their reserves will be enough to meet future claims.

With no end in sight to the crisis in Europe many reinsurers are now realising that to survive they will have to change their business models. But this kind of drastic change brings its own perils.

And then there are the tangible risks that reinsurers cover. Recent years have proved particularly bad for natural catastrophes and there is some evidence to suggest that Mother Nature is becoming more savage. In addition, there is increasing worry about the potential for man-made risks such as cyber crime. Recent computer glitches at banks have highlighted just how dependent much of the population is on technology.

But as well as providing coverage for others against these kinds of risks, reinsurers also have to protect themselves. Our survey found that three of the 12 participants were either going, or had recently gone, through training or audits on data security—evidence that the industry is taking the issue seriously.

Finally, there are the risks that no-one knows about or expects, those that the industry simply has to absorb and insulate itself against as best it can. All in all, reinsurers spend a lot of time worrying—and with good reason.

Playing by the rules

While most reinsurers believe that improved governance through better regulation is something to be welcomed, many have reservations about the burden that implementing Solvency II, in particular, will place on them.

Estimates from PwC show that the expected cost to the reinsurance industry as a whole has risen from initial EU estimates of €2 to 3 billion to closer to €4.5 billion, given the extended deadlines and added complexity of implementation. While PwC puts the average cost of implementation at €10 to 20 million for individual reinsurers, many are also worried about the amount of human resources they will need to dedicate to the job.

“All this effort is somewhat diverting reinsurers’ attention away from core activities at a time when they need to be concentrating the most. The amount of human and financial resources being spent on Solvency II is a bit concerning in places.

“While there will be long-term benefits to Solvency II, companies are spending far too much time and effort on this, particularly in the UK. There is a fear of losing focus on what they should be doing as a reinsurance company.

“We are also hiring more actuaries in order to comply and once we are compliant, the fear will be that we may have too many people. That is a bit of a concern.”

Tatsuhiko Hoshina, president and chief executive officer of Tokio Millennium Re

“The additional regulatory burden created by Solvency II sometimes creates work that doesn’t add any obvious value to the firm. Solvency II certainly has noble goals, but it has the potential to become tedious if regulators are overly pedantic and it becomes merely a box-ticking exercise, which it shouldn’t be.”

Barry Zurbuchen, chief risk officer at Allied World Assurance Company

“The regulatory environment is something that all major multi-line reinsurers are dealing with and we’re watching the situation very closely, particularly with Solvency II. One area that we’ve been particularly active in is the process of model development.

“Outsourcing is not a core part of our operational strategy, as most of the work that we do is internal, but from time to time we do obviously hire outside resources to help us and that’s certainly the case with our internal models for Solvency II.”

Jamie Veghte, chief executive of reinsurance operations at XL Re

“Initially our understanding was that the new regime would be principle-based, not rules-based, and it would take into consideration the risk specifics of the different entities. We have come to recognise that this is simply not the case.

“The new rules may mean that responsibilities for risk management, actuarial, compliance and internal audit will have to be clearly segregated. Currently as chief risk officer my responsibilities include providing ‘the second line of defence’, which includes risk management and major parts of actuarial, especially the reserving check.

“I think this will no longer be possible if the current proposals do not change. I agree that internal audit has to be segregated but how do you organise the other three functions? I think that this should be for the re/insurers to decide, rather than specified in the rules, provided that ‘real’ conflicts of interest can be avoided.

“The current structure means that companies are being bombarded with the same questions from different local regulators. I wish that we could have a real group regulation that would allow us to explain ourselves just once, instead of over and over again.”

Eberhard Mueller, chief risk officer at Hannover Re

The European issue

The crisis in Europe, and its effect on the wider world, sits prominently on reinsurers’ radar. For them, it represents a range of threats. As well as the risk that they face around their investments in potentially unsafe government bonds, they also face the prospect of less business to go round, coupled with the associated cost of adjusting their systems if the euro were to go under, which, using the London Market as an example, could potentially run into 10s of millions of pounds, according to PwC.

“Continued economic challenges and uncertainty in Europe will provide important strands of potential risk. While the sovereign debt crisis in Europe is linked to instability in the banking framework it also entails widespread austerity programmes, potential political instability and enhanced regulatory risk.”

Steve Postlewhite, acting chief risk officer at Aspen Re

“There are two key concerns with this: the current contract and the future business. Most of our clients are European, so we have run various scenarios on what does it mean to reinsurance contracts? How will it affect the contracts that are denominated in euros, and how would they survive?”

Philippe Regazonni, chief executive officer of Amlin Re Europe

“Everyone’s been worrying about the eurozone but we’re not exposed on a currency basis. We write risk and take premiums in these areas but if the currency should collapse, all that would happen for us is the claims, should they come in, would be at a different exchange rate.

“We’d deal with this the same way we dealt with it when everyone joined the euro. We went from several currencies to one, and this is simply the reverse. However, we are different from others as we are a Lloyd’s entity.”

Jeremy Adams, chief executive officer overseeing reinsurance operations at Novae Syndicates

“It is a balancing act between neither being able to afford full preparation for the worst case, nor being able to afford being unprepared. While the impact on the investment side may be foreseeable to a certain extent, implications on operational reinsurance issues would be both complex and time-consuming. When looking at our in-force business, Eurocrisisrelated claims patterns are beginning to emerge from some countries and classes of business.”

Andreas Molck-Ude, chief executive officer at New Re

A casualty of circumstance

Whether or not reinsurers are directly exposed to the troubled eurozone, nearly all are suffering under the almost non-existent interest rate environment perpetuated by the crisis. This can prove particularly harmful to reinsurers exposed to a lot of long-tail business.

The problem has not gone unnoticed. In its half-yearly financial stability report, for example, the European Insurance and Occupational Pensions Authority (EIOPA) highlighted this as a potential problem for the insurance industry.

Life insurers and pension funds are particularly affected by long-term low interest rates as their obligations to policyholders will become more expensive when the underlying premiums or contributions do not earn sufficient interest. This can be a big problem for life insurance companies and defined benefit pension schemes, the report said, as both of these products promise a guaranteed minimum rate of return to investors.

“Interest rates are a concern for all underwriting organisations. If they are writing long-tail business it is even more of an issue. For a number of years now I’ve been saying that with interest rates where they are now, it really needs to be more about underwriting than expected investment income. So yes, this is a concern.”

Mark Watson, chief executive officer and president of Argo Group

“One consequence of the current sovereign debt crisis, not only in Europe but also in the US, is the continuing low interest rate level for highly rated government bonds. This results in challenges for the pricing of long-term reinsurance contracts. In addition, a rise in inflation could lead to increased claims inflation and thus to higher claims payments in the future.”

Torsten Jeworrek, chief executive officer for reinsurance at Munich Re

“People talk a lot about the property cat side of the business and where the rates are going. But more importantly, and I stress this all the time, we are in an environment where the return on investment is not as high as it was before.

“That means that on the longer tail business, because the environment isn’t as favourable as it was in the past, the current investment returns have to be reflected in the pricing. The problem is that we haven’t really seen that movement in the long-tail casualty business. It may be going up, but not as much as is needed to reflect the reduction of investment returns.

“At the same time, I am also worried about reserves that were rated on the higher investment yields of the past, so there is a chance that the reserves that materialise might not be adequate.”

Tatsuhiko Hoshina, president and chief executive officer of Tokio Millennium Re

Emerging risks come in all shapes and sizes. They include those that have already been identified, such as ‘known modelled’ or ‘known unmodelled’ risks. However, as our interviewees point out, it is the unknown risks lurking in the shadows that can cause the most problems.

“One example of a new ‘known unmodelled’ risk is solar storms. This is an emerging risk that we are currently studying. The results are inconclusive at the moment. Maybe it will be a big risk, maybe a very small risk. We don’t know yet.

“You cannot know the unknown, but you need to prepare yourself by having a buffer on top of your capital requirements. But the capital is there for facing the unknown. While reserves are there for dealing with known risks, capital is there to absorb unknown shocks.”

Philippe Trainar, chief risk officer at French reinsurer SCOR

“Some risks have been known about for a significant amount of time, but still remain unmodelled, such as Thai flood. Everybody knew there were Thai flooding risks and in fact the country has suffered from big flood losses in the past. Still the risk was not modelled and was not included in pricing on individual accounts, or even modelled as an aggregate for some companies. The lack of aggregate control was a large factor in the cause of such a big industry loss last year.

“At the same time, those are called the ‘known’ unmodelled. The ‘unknown, unmodelled’ are the tricky ones. The industry needs to be aware that these types of losses do occur and somehow they need to be incorporated in their pricing, so when these events occur, there is some fund to cover it.”

Tatsuhiko Hoshina, president and chief executive officer of Tokio Millennium Re

“There are always emerging risks which create both challenges and opportunities. Today fracking, cyber and nano technologies are just three examples that present opportunity for research, risk management ideas and product development.”

Tad Montross, chief executive officer and chief risk officer at Gen Re

Shifting sands

Even risks that have been extensively modelled are subject to change. Development in both developed and developing nations, such as Brazil, Russia, India and China (the BRICs), means that infrastructure is constantly evolving, increasing in size and complexity. For example, despite faltering slightly, China’s economy is still growing at around 6 to 7 percent. This in turn means that the man-made risks covered by insurers, and then subsequently reinsurers, are also evolving.

Because of the hugely significant role that our climate plays in terms of natural perils, reinsurers have invested heavily in both climate change research and eco-friendly technologies, demonstrating the concern they have about changes in the environment around them.

“While climate change is an unknown, the frequency and severity of catastrophes has increased over the past 25 years and requires a rethink over coverages and pricing.”

Tad Montross, chief executive officer and chief risk officer at Gen Re

“We need to be careful not to jump to conclusions too quickly. Take for example sea temperatures rising. It may actually be beneficial, to an extent, if the sea surface gets warmer than it is. Because then the gradient-the gap between the sea surface and the upper atmosphere that fuels hurricanes-is closing and becomes less dangerous. But, you have to be very careful drawing conclusions.”

Eberhard Mueller, chief risk officer at Hannover Re

“You really need to understand what kind of insured value you have in clusters in emerging markets: Aspen is investing significant R&D resources in addressing this issue. The old paradigm that these areas have no insured value has gone, and we have to put more basic upfront analysis in to thinking about how we underwrite in these areas.”

Steve Postlewhite, acting chief risk officer at Aspen Re

Not a model approach

The ability to model risks provides reinsurers with an essential tool in managing their exposures. However problems can occur when reinsurers, and their cedants, become too reliant on models and forget to use their heads in making decisions and calculating risk.

“Much like the banking industry, the insurance industry has become reliant—maybe over-reliant—on models. The recent significant changes to the RMS models underscore this risk.”

Tad Montross, chief executive officer and chief risk officer at Gen Re

“Back in 2000 we tried to encourage clients to incorporate more modelling to help them manage their portfolio and their probable maximum loss (PML), so that they could buy reinsurance cover accordingly. The pendulum has now swung in the opposite direction, with cedants using models as if they are an exact science, instead of just a guideline. This over-reliance on models is a bit of a concern to me.”

Tatsuhiko Hoshina, president and chief executive officer of Tokio Millennium Re

“In line with increasing model complexity and data volumes, also ‘model devoutness’ is rising as fewer and fewer people feel competent to challenge model results. Often enough, a good portion of commercial common sense is helpful when being applied to modelling results.”

Andreas Molck-Ude, chief executive officer at New Re

“By their nature, models are a simplified view of what will happen in the future. Circumstances rarely turn out significantly better than the way they were modelled. However, often they can turn out to be substantially worse than modelled because the model does not include all possibilities.”

Barry Zurbuchen, chief risk officer at Allied World Assurance Company

A threat on the wire

As essential as the Internet is to reinsurers’ day-to-day operations it—and mobile technology in general—also poses significant risks. While the threat of data loss, whether from hackers and careless staff, is already well known, new regulations in many countries mean that reinsurers face significant fines for losing sensitive data. This is increasing the pressure felt by reinsurers to keep their data well guarded.

“The risk involved is rising constantly both because of increasing storage capabilities of small devices and because of progressing criminal energy to tap into company data. Furthermore, the motive to create reputational damage to companies is far more relevant now than in the past.”

Andreas Molck-Ude, chief executive officer at New Re

“We have had a number of attacks on our company over the last 10 years, but our firewalls have been able to keep out the potential hackers. So it’s definitely possible.”

Mark Watson, chief executive officer and president of Argo Group

“Cyber risk and data security is a big issue for us as a company. We are tightening up a huge amount of our own data security, especially what data can leave the company. If someone drops a USB stick on the way out of the office and it’s not encrypted—it’s an absolute no-no.

"Encrypting is our standard and although we’re probably an unlikely target for professional hackers seeking publicity, we have gone through the routines of having professional hackers try to penetrate our systems to find weaknesses. It’s always a balance between disaster recovery versus the security of accessing or losing it.”

Jeremy Adams, chief executive officer overseeing reinsurance operations at Novae Syndicates

“Preventive action includes developing facilities to store your data independently of your IT system. That way your equipment will not all be connected at the time of an attack, enabling you to use any unaffected equipment to repatriate your data and to operate independently if one or several systems are compromised after an attack.”

Philippe Trainar, chief risk officer at French reinsurer SCOR