«Protecting the poor A microinsurance compendium Edited by Craig Churchill Protecting the poor A microinsurance compendium Protecting the poor A ...»
Calculating the reserves is only the first step. The microinsurer must make sure that the reserves are fully funded at all times and that the investments backing the reserves are properly managed.
Risk and financial management 263 4 Reinsurance Reinsurance is a risk-management tool that should be used by the microinsurer if possible. It is generally used to stabilize the financial condition of the insurer. Chapter 5.4 deals with this subject in greater detail, but a brief discussion is warranted here since reinsurance is an important aspect of financial management.
In commercial markets, reinsurance is used to meet regulatory capital requirements or even as a source of capital for companies with limited means.
Sometimes, insurers buy reinsurance in order to receive professional advice from reinsurers.
Reinsurance is not a magic wand you can wave to turn a losing proposition into a viable entity. The a priori condition for reinsurance to add value to the business results is that the insurer has a viable product or one that can be made viable if appropriate measures are taken. This requires the maintenance of appropriate records of the insured, claims management, financial reporting and an appropriately articulated business plan.
There are several types of risks faced by an insurer which can be managed through reinsurance. Catastrophe risk is a rare and asymptomatic risk such as an earthquake or tsunami, which particularly affects asset security and life insurance portfolios. Similarly, a major epidemic such as the widely expected avian flu could affect health insurers. A portfolio that is too geographically concentrated is much more susceptible to the financial impact of a catastrophe.
There is no single and universal definition of the dimension of damages that constitute a “catastrophe”; the term has a different meaning for climate extremes than for health impacts or wild fires. In some cases the catastrophe is measured in relation to the size of the portfolio, while in others it may be expressed relative to household annual income. Generally, a single catastrophic event could impair the financial condition of the insurer due to the unusual number of claims.
Catastrophe coverage is available to most commercial insurers – the premium is usually very small in relation to the cover due to the very small probability of occurrence. Reinsurers can take on this risk because they spread the risk across the globe by, in turn, reinsuring with other reinsurers.
The international nature of reinsurance enables risks to be spread across national boundaries.
Claims severity risk refers to a disproportionate risk within a pool of homogenous smaller risks. A credit life programme covering 20,000 loans of US$500 and one loan for US$10,000 is a very clear, simple example. In this case, the insurer should only retain a small portion of the single large risk, say 264 Microinsurance operations US$500 of the US$10,000, and cede the remaining US$9,500 to a reinsurer because a claim from that particular borrower would severely impact or even wipe out the entire surplus of the programme. Such a reinsurance cover is termed surplus or individual excess-of-loss reinsurance.
Aggregate claims are affected by claims incidence risk, which is a fluctuation around the mean of the claims distribution, i.e. the expected number of claims. In practical terms, the actual value of claims is greater than the expected value factored into the rates. A microinsurer can manage this type of risk through quota share and/or aggregate stop-loss reinsurance.
For pension or disability plans, duration of claim or the probability of someone collecting a pension or disability benefit longer than expected is a risk that impairs the financial results. Individual excess-of-loss cover could be used to manage this risk if it is available.
Reinsurance is also used to even out irregular claims patterns. Over a certain period of time, such as a year, an insurance company may be able to pay all its claims. However, these claims may not be spread evenly during the year and may instead come in irregular patterns such as a flurry of claims or a large claim in a particular month. Reinsurance allows the reinsured to smooth out its claims obligations and to reduce the uncertainties of irregular claims. Reinsurance also enables insurers to limit year-to-year fluctuations.
Essentially, the reinsured borrows from the reinsurer in bad years and pays back when its loss experience is good.
For some microinsurers there is little need for surplus or quota share reinsurance. A specific example of this is when a microinsurer covers a “large” number of “homogeneous risk” clients with a simple term life product that has identical “low” coverage for all. In this case, the number of claims is likely to remain stable from one period to the next since the number of clients is large – in other words, the variance for claims incidence is small due to the Law of Large Numbers. The actual number of claims should be close to the expected number of claims if the pricing has been done properly.
Since the insured amounts are assumed to be identical for all participants there is no claims severity risk (i.e. zero variance in benefit payout when a claim does happen).
Other microinsurers, however, do need surplus or quota share reinsurance because they cover a relatively “small” number of lives (hence they have a larger variance in incidence than for a larger risk pool) or because they have little or no capital. Reinsurance would also be necessary if a few individuals represent a significant portion of the total sum insured. Some actuaries use the rule of thumb that individual risk retention should not exceed 0.5 per cent of the microinsurer’s capital and surplus. So, for example, for a microinsurer with US$100,000 capital and US$20,000 surplus, the Risk and financial management 265 maximum retention should be 0.5 per cent of US$120,000 or US$600 – the remaining risk should be reinsured. This formula is too simplistic because it does not take into account the number of risks covered, but it provides an initial indication.
It is very prudent for microinsurers to take out catastrophe reinsurance if it is affordable and available. However, one of the major hurdles is reinsurers’ reluctance to provide reinsurance to microinsurance schemes because they do not understand the microinsurance market. In addition, many microinsurers are not legally registered and the reinsurer is restricted to doing business only with licensed insurers.
The case study on AIG Uganda illustrates the limited relevance of reinsurance for some microinsurance products. For this commercial carrier, the decision not to reinsure is logical as the sums insured are small and spread over 1.6 million people living in a large geographical area. Perhaps catastrophe cover would be a suitable risk-management strategy for this pool.
MUSCCO in Malawi, however, could not buy reinsurance even if it wanted to because it is not a registered insurer. Furthermore, although it does not appear vulnerable to an imminent and sudden risk of increased mortality rates, it has built up a large fund to cover future claims increases that could also cover claims fluctuations. As with AIG, however, catastrophe reinsurance would be advisable if it were available.
5 Investment management As mentioned above, the objective of a good investment programme is to optimize the value of the investment earnings while maintaining appropriate liquidity and asset security to meet obligations as they arise. This is achieved by diversifying by asset type, with a cap on any one investment. Many organizations define their vision of a sound investment policy by outlining the objectives, responsibilities of managers, monitoring reports, categories and permitted asset types.
A tendency and common mistake made by developing insurers is to overinvest in property, often for reasons of prestige or in the (speculative) hope that its value will rise and produce a large capital gain. As a general rule, property should not exceed 10 per cent of invested assets, especially since it is very illiquid.
A critically important function for any insurer exposed to longer-term liabilities, such as endowments and pensions, is matching anticipated positive cash flow generated by assets (such as anticipated maturities, interest earnings and dividends) to expected negative cash flow arising from liabilities (largely expected benefits to be paid). This is known as asset-liability 266 Microinsurance operations matching.7 The objective is to ensure that the pattern and magnitude of positive cash flow closely matches that of the negative cash flow. This must be constantly monitored and in practice requires a projection of the liability stream consisting of expected claims and expenses (for example), which is then compared to the expected inflow stream made up of scheduled interest payments and asset maturities (for example) arising from the asset portfolio.
The ideal is to have an exact or near match of the two streams so that they compensate each other. If the streams are significantly mismatched, the insurer will experience cash flow problems in the future.
To correct a mismatched situation requires a reshuffling of assets, but this creates a new risk: finding an asset with equal or better returns and with similar quality. If an asset is traded for another asset, the investment yields assumed in the pricing must be retained.
Another risk related to longer-term products is the reinvestment risk.
This arises when the insurer takes on a long-term liability or a fixed guarantee, but does not have assets with the required returns and equal durations to cover the guarantee.
For example, suppose a microinsurer promises a fixed endowment 20 years in the future and the actuary has assumed a 6 per cent interest rate over the entire 20-year period to determine the premium rate. If the microinsurer is limited, for example, to investing in five-year term deposits currently yielding marginally higher than 6 per cent, it faces a very significant pricing and reinvestment risk because of the uncertainty in reinvestment interest rates as the five-year term deposits mature. If five-year term deposit yields drop below 6 per cent in later years, the microinsurer could be wiped out, depending on the size of that portfolio and on the degree of mismatch. Even a few basis points can be devastating due to the effect of compounding interest. The only sure way to manage this risk is to match interest rate guarantees (both interest amount and duration of the guarantee) with the available assets at the time that the guarantee is made.
Recently, the Provident Fund of CARD MBA was prone to this risk because it had promised an 8 per cent return over 20 years to members on their Php 5 per week savings deposits. This guarantee was not covered appropriately because the organization was limited to short-term investments or investments in related organizations.
CARD’s loan portfolio yielded a net rate of approximately 8 per cent in late 2003, after deducting 20 per cent investment tax and expenses. However, the risk was reduced because members dropping out of the scheme before three years of continuous membership forfeited their savings – the forfeited savings increased portfolio yield and this covered some of the mismatch risk.
The danger was that the organization was not measuring the net degree of risk that it faced at the time (and will continue to face until the policies mature). The organization has since remedied this risk and is now advising members that interest credited will depend on the actual net investment yields.
Table 28 illustrates the potential effect when actual net yields are below 8 per cent. The illustration assumes that 100,000 members deposit Php 5 per week for 1,044 weeks (20 years) and then claim their deposits at the guaranteed 8 per cent per annum. The calculation also assumes that the forfeited savings of early drop-outs have been factored into the 20-year net yields.
Potential effect of investment mismatch on CARD’s Provident Fund – An illustration Table 28