Reinsurance as a risk and capital management tool for Maltese insurance companies

Abstract

Widely advertised corporate failures and the European Commission's Solvency Il initiative are exerting pressure on insurers worldwide to improve their risk and capital management capabilities and to adopt a unified and integrated approach towards the management of their risk profile and capital base. Against the backdrop of these developments, the study focuses on one of the fundamental risk and capital management tools available to insurance companies worldwide, namely reinsurance. The objective is to evaluate reinsurance within the risk and capital management structures and processes of local insurance providers writing general business of insurance. A rigorous literature review introduces economic capital as the concept which lies as the heart of Enterprise-wide Risk Management (ERM) by providing the link between risk and capital. It stresses the importance of an ERM framework that permeates the organisation and provides for· maximisation of economic value through the amalgamation of risk and capital management. The literature review proceeds to discuss the manner in which reinsurance fits within ERM. First, it analyses the full implications of reinsurance, including the benefits, costs and the risks arising from reinsurance contracts. Subsequently, it emphasises the necessity of a sound reinsurance management strategy to serve as a basis for the development and implementation of the reinsurance program, thus enabling the company to recognise and manage the implications of reinsurance diligently and effectively. The empirical process consists of in-depth personal interviews with Maltese insurance companies falling within the scope of the study and the Maltese insurance regulator. The former are divided into two groups, namely companies predominantly writing risks situated in Malta ('local companies ') and managed companies writing risks situated outside Malta ('managed companies '). The findings reveal that whilst both local and managed companies understand the theoretical risk and capital management properties of reinsurance, local companies are encountering difficulties in understanding the actual implications of reinsurance on the company's aggregate net risk exposure and risk-based capital. These difficulties stem from a number of factors, namely, the absence of risk models, fragmented risk management, reliance of capital management on a deficient solvency regime that lacks a clear connection between risk and capital and heavy dependence on reinsurance brokers. In light of the literature review and the empirical findings, the study concludes with a number of recommendations for local companies, managed companies and the regulator. These recommendations revolve around the need to strengthen and integrate the ERM pillars and to formalise and solidify reinsurance management structures and processes. These improvements require substantial eff orts, cultural changes and management commitment, coupled with regulatory and supervisory initiatives. Nonetheless, the suggested improvements should empower Maltese companies to obtain an improved and holistic understanding of the true implications of reinsurance, thereby leveraging reinsurance decisions, maximising shareholder value and equipping themselves for the challenges of the upcoming Solvency Il.