Strategic Capital Management in Times of Economic Uncertainty

Original article was published by Vesttoo on Artificial Intelligence on Medium


Strategic Capital Management in Times of Economic Uncertainty

P&C insurers are currently facing unique challenges worldwide. Capital market solutions provide insurers with strategic capital relief at lower costs along with a competitive advantage in near-recessionary economic environments

Capital market solutions provide strategic capital relief

Non-life insurers in mature markets have been exposed to increasing challenges in recent years. The near-recessionary economic environment, rising governmental scrutiny and regulatory costs, intense competition, limited economic growth and historically low interest rates have all contributed to lower profit margins throughout the sector and increased exposure to liabilities. Furthermore, the global pandemic is currently sending shock waves throughout markets around the world, affecting the insurance industry everywhere in ways we have yet to discover.

In the current formidable economic and regulatory environment, with global markets on the verge of recession, P&C insurers must find innovative and flexible ways to limit risk exposure and optimize capital management in order to control costs, stimulate growth and stay afloat in these uncertain times.

Limited growth in mature P&C markets

Traditional Reinsurance Has Limited Capacity

One of the ways P&C insurers have been managing capital and risks is through traditional reinsurance. There are various different methods of reinsurance, each with its own advantages and disadvantages. The most common reinsurance solutions on the market include the following:

  1. Quota Share deals (QS)– In these reinsurance deals, the insurer and reinsurer split portfolio losses proportionally between them at a predefined rate. The reinsurer benefits from its relative share in premiums and upside, limiting the insurer’s potential profit from the portfolio.
  2. Excess of Loss (XoL)– XoL deals are a very common form of reinsurance, in which the reinsurer compensates the insurer for losses that exceed a specified limit (non-proportional). The limit is calculated for every claim separately and not for the whole portfolio, therefore if a portfolio performs badly but does not reach the XoL limit, the insurer takes all of the losses. These deals are beneficial in portfolios that may experience higher losses per claim.
  3. Loss Portfolio Transfer (LPT)– The reinsurer accepts the insurer’s existing open and future claim liabilities in return for the transfer of the insurer’s loss reserves, often at a profit for the reinsurer. Similarly to QS deals, in LPT reinsurers benefit from the portfolio’s premiums and upside, in addition to the capital from loss reserves.
  4. Aggregate Stop-Loss (ASL)– Stop-loss deals are similar to XoL deals, with the difference that attachment and exhaustion points are calculated for the entire portfolio according to policyholders’ risk profiles, demographic trends and more. The reinsurer takes losses between the two calculated points. In these deals, upside and premiums are retained by the insurer.

On the whole, existing reinsurance solutions are costly and limited in their capacity and flexibility. The reinsurance market can’t cover the industry’s immense need for capital. The current hard market and global pandemic may further limit reinsurers’ capacity for reinsurance deals in the near future. What is more, insurers retain between 20–30% of the risk on their balance sheets in most deals, a relatively large proportion for which they need complementary solutions.

Capital Market Solutions to the Rescue

Innovative solutions taking advantage of the unlimited capacity provided by the capital markets can help insurers better manage their capital and the risk/liabilites they are exposed to. Institutional investors substitute traditional reinsurers on the other side of the deal, providing a bridge to the capital markets and the capital needed for SCR and risk margin relief. Capital market solutions also decentralize the reinsurance market, providing more options for partners when looking for capital relief, improving deal pricing. Moreover, capital market solutions do not fall under Solvency II, therefore reducing regulatory costs and increasing capital relief for every dollar spent.

Due to the way Aggregate Stop Loss deals are structured and modelled, they are especially suited to take advantage of the capital markets, while allowing insurers to retain premiums and upside from their portfolio which they can utilize for other purposes. In addition, technologies such as artificial intelligence and machine learning can streamline the risk modeling process along with attachment and exhaustion point calculation, greatly improving deal flexibility and efficiency, with fast time-to-market and flexible deal maturity and exit points.

Despite the enormous challenges facing P&C insurers worldwide in the current economic environment, innovative insuretech solutions taking advantage of the capital markets provide insurers with efficient and cost-effective capital management, giving them a competitive edge over their competition and the breathing room they need to stimulate growth and increase profit margins.

About Vesttoo

Vesttoo has developed advanced technologies for data-driven risk management, transferring actuarial risk to financial risk through the capital markets. Vesttoo specializes in risk modeling and alternative risk transfer for the Life and P&C insurance markets, providing insurers with a low-cost strategic risk management solution for immediate capital relief, value enhancement and liability hedging.