CREDIT RISK IN THE REINSURANCE INDUSTRY - Jo Oechslin, CRO, Munich Re Monte Carlo, 14 September 2010
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CREDIT RISK IN THE REINSURANCE INDUSTRY Jo Oechslin, CRO, Munich Re Monte Carlo, 14 September 2010
State of the insurance industry
Industry
Industry eventually
eventually survived
survived crisis
crisis relatively
relatively unharmed,
unharmed, with
with notable
notable exceptions
exceptions
However,
However, industry
industry threatened
threatened by
by spill-over
spill-over of
of regulatory
regulatory concepts
concepts directed
directed to
to
banks
banks
At
At times,
times, risk
risk capacity
capacity was
was an
an issue
issue (sometimes
(sometimes unnoticed)…
unnoticed)…
…but
…but industry
industry was
was lucky
lucky that
that Solvency
Solvency IIII has
has not
not been
been in
in place
place at
at year
year end
end 2008
2008
Uncertainty
Uncertainty around
around Solvency
Solvency IIII calibration
calibration has
has recently
recently depressed
depressed insurance
insurance
sector…
sector…
…but
…but finally
finally there
there are
are some
some good
good news:
news: QIS5
QIS5 calibration
calibration looks
looks more
more reasonable
reasonable
than
than what
what could
could be
be expected
expected
Future
Future earnings
earnings potential
potential under
under pressure
pressure due
due toto lower
lower investment
investment income
income ––
insurance
insurance companies
companies again
again in
in search
search for
for yield
yield enhancement
enhancement
Industry
Industry still
still too
too dependent
dependent on
on banking
banking industry
industry –– government
government debt
debt an
an increasing
increasing
concern
concern
2Overview on current regulatory activities
Macro
Macro prudential
prudential response
response Micro
Micro prudential
prudential response
response
EU:
EU: Establishment
Establishment of
of European
European Systemic
Systemic Risk
Risk Insurance
Insurance Banking
Banking
Board (ESRB) and strengthening of
Board (ESRB) and strengthening of the 3L3the 3L3 Solvency IIII
Solvency Revise Basle
Revise Basle IIII and
and
increase
increase capital
capital
committees (CEIOPS/CEPS/CESR)11
committees (CEIOPS/CEPS/CESR) (Level
(Level 11 decision
decision taken;
taken; requirements
requirements
G20:
G20: Turns
Turns FSF
FSF (Financial
(Financial Stability
Stability Forum)
Forum) into
into implementation
implementation ongoing)
ongoing) Discussions:
Discussions:
the FSB (Financial Stability Board)
the FSB (Financial Stability Board) Living
Living will
will
US Too
Too big to
big to fail
fail
US treasury:
treasury: Creation
Creation of
of ‘Financial
‘Financial Services
Services Leverage
Oversight Leverage ratio
ratio
Oversight Council’
Council’ Burden
Burden sharing
sharing
Inclusion
Inclusion of
of insurance
insurance industry
industry still
still open;
open; Insurance
Insurance industry
industry less
less prone
prone to
to systemic
systemic risk;
risk;
insurance
insurance industry
industry needs
needs adequate
adequate measures
measures proposed
proposed forfor banks
banks not
not sensible
sensible for
for
representation
representation inin new
new bodies
bodies insurance
insurance companies
companies
1 European supervisory boards for insurers, banks and securities trading (CEIOPS: Committee of European Insurance
and Occupational Pensions Supervisors, CEPS: Centre for European Policy Studies, CESR: Committee of European 3
Securities Regulators).Macro-prudential response
Geneva Association study on systemic risk in
insurance
Criteria for systemic relevance Conclusions of GA study
FSB
FSB criteria
criteria Criteria
Criteria should
should bebe applied
applied toto activities,
activities, not
not to
to institutions
institutions
Size:
Size: “The
“The volume
volume of of the
the Only
Only few
few activities
activities of
of insurance
insurance groups
groups areare systemically
systemically
financial
financial services
services provided
provided by by relevant
relevant
the
the individual
individual component
component of of the
the −− Derivatives
Derivatives activities
activities (incl.
(incl. CDS
CDS writing)
writing) on
on non-insurance
non-insurance
financial
financial system”
system” balance sheets
balance sheets
Interconnectedness:
Interconnectedness: −− Mis-management
Mis-management of of short-term
short-term funding
funding raised
raised through
through
“Linkages
“Linkages with
with other
other securities
securities lending
lending and
and commercial
commercial paper
paper
components
components of of the
the system”
system”
Insurer
Insurer wind-ups
wind-ups are
are stable
stable processes
processes that
that do
do not
not pose
pose aa
Substitutability:
Substitutability: “The“The extent
extent systemic
systemic risk
risk
to
to which
which other
other components
components of of
the 55 measures
measures recommended
recommended
the system
system can
can provide
provide thethe
same
same services
services inin the
the event
event ofof aa 1.
1.Implement
Implement comprehensive,
comprehensive, integrated
integrated and
and principles-based
principles-based
failure”
failure” supervision
supervision of
of insurance
insurance groups
groups
IAIS
IAIS Addition
Addition 2.
2.Strengthen
Strengthen liquidity
liquidity risk
risk management
management
Timing:
Timing: Allowing
Allowing for for the
the fact
fact 3.
3.Enhanced
Enhanced regulation
regulation of
of Financial
Financial Guarantee
Guarantee Insurance
Insurance
that systemic insurance
that systemic insurance risk risk 4.
4.Establish
Establish macro-prudential
macro-prudential monitoring
monitoring with
with appropriate
appropriate
does
does not
not typically
typically generate
generate insurance representation
insurance representation
immediate
immediate shock
shock effects,
effects, butbut 5.
5.Strengthen
Strengthen risk
risk management
management practices
practices
plays
plays out
out over
over aa longer
longer time
time
horizon
horizon
Source: Geneva Association 4Macro-prudential response
Credit risk in the reinsurance sector
CDS
CDS of
of major reinsurers11
major reinsurers “Hidden
“Hidden dangers”
dangers” (past
(past and
and future)
future)
Munich Re 53 bp Reinsurers
Reinsurers sometimes
sometimes considered
considered asas „naive
„naive
capacity“
capacity“ for
for credit
credit risk,
risk, specifically
specifically in
in times
times of
of
crisis.
crisis. Examples:
Examples:
Structured
Structured credit
credit
Financing
Financing transactions
transactions
Leveraged
Leveraged buy-out
buy-out
Fronting
Fronting
Etc.
Etc.
Importing
Importing of
of credit
credit risk
risk through
through banking
banking
exposures
exposures
CDS
CDS spreads
spreads of of reinsurers
reinsurers during
during crisis
crisis have
have been
been driven
driven by
by Lower
Lower investment
investment yields
yields may
may bring
bring yield
yield
aa variety
variety of
of risks,
risks, of
of which
which one
one may
may be
be credit
credit risk.
risk.
enhancement
enhancement strategies
strategies back
back on
on the
the agenda
agenda
CDS
CDS spreads
spreads can
can be
be distorted
distorted by
by lack
lack of
of liquidity
liquidity
1 Source: Bloomberg (1.1.2008–27.07.2010). Universe: Munich Re, Berkshire, Hannover Re, Scor, Swiss Re, XL Re. 5Micro-prudential response
Solvency II brings more discipline to the insurance
industry
Solvency
Solvency IIII acts
acts as
as aa catalyst…
catalyst… …to
…to resolve
resolve some
some old
old industry
industry issues
issues
Example:
Example: Primary
Primary life life insurance
insurance
Issue: Long-term
Issue: Long-term guarantees
guarantees and and options
options often
often not
not properly
properly
priced
priced and
and hedged
hedged
Solvency II:
Solvency II: Requires
Requires capital
capital for
for mismatch;
mismatch; demonstrates
demonstrates
where return is insufficient for risk
where return is insufficient for risk taken taken
Solution: Improving
Solution: Improving ALM, ALM, product
product design
design
Example:
Example: Reinsurance
Reinsurance
Issue: Reinsurance
Issue: Reinsurance programmes
programmes not not always
always optimal
optimal inin
terms
terms of
of risk
risk transfer
transfer
Solvency II:
Solvency II: Reinsurance
Reinsurance matters
matters forfor capital
capital requirements
requirements
Solution: Impact of reinsurance structures can be
Solution: Impact of reinsurance structures can be
measured and optimised
measured and optimised
Example:
Example: Investments
Investments
Issue: Insufficient
Issue: Insufficient profitability
profitability of
of underwriting
underwriting compensated
compensated
by taking high investment
by taking high investment risks risks
Solvency II:
Solvency II: Risk
Risk capacity
capacity places
places limit
limit on
on this
this strategy
strategy
Solution: Focusing
Solution: Focusing on on profitable
profitable underwriting
underwriting
6Micro-prudential response
Solvency II to fully crystallize the value of the reinsurance
business model
Risk
Risk transfer
transfer –– Illustrative
Illustrative Deduction
Deduction on
on capital
capital relief
relief for
for the
the
Primary
Primary insurer’s
insurer’s Reinsurer’s
Reinsurer’s
counterparty
counterparty default risk11
default risk
portfolio
portfolio portfolio
portfolio
Risk capital Capital relief Additional risk capital
€mFirst real test for Munich Re’s risk management
frameworks after 2002-2003 crisis
ERM developments at Munich Re
Development and implementation Reality check Evaluation and enhancements
Strategic
Strategic decision
decision taken
taken Subprime
Subprime crisis
crisis in
in 2007
2007 Efforts
Efforts around
around ERM
ERM have
have
after
after 2002–2003
2002–2003 crisis:
crisis: and
and subsequent
subsequent capital
capital prevented
prevented
Redesign market
market crisis
crisis in
in 2008
2008 Munich
Munich Re Re from
from the
the worst
worst
Redesign ofof investment
investment strategy
strategy
to constitute an extremely
constitute an extremely in this crisis
in this crisis
to reduce
reduce dependency
dependency on on capital
capital
markets; taxing
taxing environment
environment
markets; state-of-the-art
state-of-the-art ALM
ALM Strengthens
Strengthens position
position of
of ERM
ERM
implemented
implemented First
First real
real test
test of
of ERM
ERM teams
teams
Sustainable framework
framework
Sustainable profitability
profitability Identification
Identification of
of areas
areas for
for
achieved
achieved in
in core
core businesses
businesses Highlights
Highlights thethe improvements
improvements ongoing
ongoing
Central importance
importance of of risk
risk
Central ERM
ERM teams
teams established
established
under management
management in its in its
under CRO
CRO leadership
leadership (2004);
(2004);
risk original
original role
role –– in
in addition
addition
risk governance/measurement/
governance/measurement/
reporting to
to the
the business
business enabler
enabler
reporting strengthened
strengthened
2002 crisis has triggered necessary developments of ERM
8Strengthening country risk management in light of EU
sovereign debt crisis
Measures being considered
Agency
Agency ratings
ratings complemented
complemented with
with market
market parameters
parameters (like
(like with
with corporate
corporate
County
County limit
limit debt)
debt)
system
system Limits
Limits for
for previously
previously unlimited
unlimited countries
countries (e.g.
(e.g. AAA
AAA countries)
countries)
Consideration
Consideration ofof asset
asset classes
classes as
as alternative
alternative to
to government
government bonds
bonds
Investment
Investment Challenging
Challenging traditional benchmarks, since higher leveraged countries have
traditional benchmarks, since higher leveraged countries have
benchmarks
benchmarks over-proportional weight in index
over-proportional weight in index
In-depth
In-depth analysis
analysis of
of existential
existential scenarios
scenarios
Scenario
Scenario Quantitative
Quantitative assessment
assessment of of these
these scenarios,
scenarios, considering
considering likely
likely policy
policy reaction
reaction
analysis
analysis Evaluate
Evaluate potential
potential risk
risk mitigating
mitigating measures
measures (risk
(risk // return
return trade-off)
trade-off)
Assess
Assess current
current M&A
M&A strategy
strategy inin respect
respect of
of country
country risk
risk
Strategic
Strategic Development
Development ofof strategies
strategies for
for aa potential
potential country
country default,
default, considering
considering the
the
considerations
considerations legal setup and the nature of the business of the respective entities
legal setup and the nature of the business of the respective entities
Assessment
Assessment ofof potential
potential expropriation
expropriation scenarios
scenarios
European sovereign debt crisis have triggered changes at MR risk setup
9Historical Analysis: Munich Re managed three major
economic crises in Germany in the 20th century
Economic environment Impact on Munich Re
Hyper- Initially, claims inflation leading to high combined
Default of German government and corporate
inflation ratios, subsequently new contract conditions
bonds
1922/23 introduced (e.g. interim premium adjustments)
Depreciation of saving accounts and life insurance
Munich Re investments only partially affected due
policies
to foreign participations and real estate
Collapse of economic life (salary depreciation,
Strong competitive position of Munich Re
increasing unemployment)
due to available capacity
World Decreasing turnover of companies Drop in premium by 25%
economic Crash in stock markets and high corporate default High losses in credit and life insurance
crisis rates Positive claims development
1929–32 Protectionist trade policy Overall positive and relatively stable returns in
High unemployment rates each year
Monetary Munich Re suffered losses due to the depreciation
Increased money supply and subsequent inflation in
reform of Reichsmark
Germany (Reichsmark)
1948 Rebuilding of foreign business accelerated by rapid
Default of German government and corporate
setup of the DM opening balance sheet
bonds
Financial strength was re-established within
90% depreciation of private pension policies
three years (e.g. premium increase by 30%)
Munich Re successful in mastering prior crises,
but current situation requires analysis of further scenarios
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