Retrospective reinsurance solutions are currently experiencing a lot of interest from the market, most likely due to various return on equity (ROE) pressures faced by mutuals in the current environment. In this blog I explore what we really mean by retrospective insurance and why it’s of interest right now.
Most reinsurance contracts incept without any incurred claims, and enable the ceding insurer to recover the cost of losses that occur throughout the policy year; retrospective solutions are backward looking. This means they cover claims that have already occurred, but whose ultimate costs are uncertain.
By reinsuring past claims, ceding companies are able to protect against the possibility that claim estimates are insufficient due to the unexpected development of known losses, or the discovery of unknown losses (reserving risk), and the possibility that carried reserves may pay out more quickly than anticipated (timing risk).
Ceding reserve risk can potentially help address some of the challenges on both sides of the ROE equation.
What’s impacting returns?
Returns are being affected by low interest rates. Premiums collected by insurers are mainly invested in fixed income securities. If interest rates are low, these assets yield less, reducing earnings. The market is also experiencing an over-supply of capital (partly due to low interest rates), which has led to downward pressure on rates in many sectors. Combined, these two areas put pressure on the returns being generated.
But there’s also pressure on the equity side. We’ve seen the introduction of risk-based capital (RBC) regulation in a number of territories. RBC generally requires insurers to increase the amount of capital they hold to support the various risks being taken. The increase in capital requirements is being felt particularly by mono-line mutuals, which lack diversification and therefore appear to be penalised by the RBC system.
The final challenge is that mutuals tend to have a more limited range of options in respect to their funding, which makes preservation of capital all the more important.
How can retrospective reinsurance help alleviate these pressures?
Retrospective reinsurance helps limit the risk that loss reserve deterioration will impact earnings. This can have an impact on the amount of capital regulators require held, or on the financial strength rating assigned. It can also provide a degree of certainty. By ceding loss reserves to a third party, you are able to crystallise the underwriting result. In some cases it may be possible to transfer loss reserves for less than book value. This would generate a balance sheet gain, which in turn reduces the need to look for capital elsewhere and mitigates the lack of diversification inherent in the mutual model.
Ceding loss reserves will also reduce the impact that low interest rates will have on overall profitability. In a low-interest-rate environment, capital is allocated to support loss reserve “risks”, but because of the low or negative yields, it doesn’t make a significant contribution to the overall ROE of the enterprise. Could this capital be better deployed elsewhere? This would be possible if reserve risk was managed on the reinsurer’s balance sheet.