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By CHRIS SUCHAR, executive vice president, professional services, North America, for DFA Capital Management Inc, a provider of ERM software for the insurance and financial services industries

Historically, the reinsurance industry's risk management practices have been characterized as "looking for the missing keys under the street lamp." In other words, focusing on insurance underwriting risks while not giving due diligence to other risk exposures. Unfortunately, it was some of those "other" exposures that have inflicted real pain in the past year as the capital markets turned upside down.

The ability to manage underwriting risk has developed and matured over time because these are the core business activities of the reinsurance industry. But in other areas--such as the capital markets--risk management processes and tools are still largely unused or in their infancy because the exposures have only recently been recognized.

Equity market risk has, of course, been highlighted by the dramatic drops in most markets since mid-2008. Old assumptions have been disproved, as the downdraft was much faster and more correlated across markets than thought possible.

Interest rates and credit spreads have also moved dramatically. Many reinsurers pursued investment strategies that focused on high-grade fixed income securities, but those securities lost considerable value when credit spreads widened in 2008.

Structured securities contained exposures to the housing markets and other credit markets, which were not well understood by the many investors that held them. Interestingly, the due diligence to understand the exposure on a collateralized mortgage obligation (CMO) tranche was--and still is--very similar to underwriting an excess of loss treaty. The data was available, yet many did not "do their homework" in this area.

Finally, liquidity risk has been highlighted as an area of weakness, as some have been forced to liquidate securities below their "intrinsic" value because of a need to settle claims for Hurricane Ike at a time of disruption in the markets.

How can reinsurers control or mitigate these risks going forward? The first step is to identify the exposures and the magnitude of potential loss. This requires:

--Understanding the range of possible economic and capital market scenarios, not just based on what's been observed in the last few years, but the full scope of history

--Contemplating economic scenarios never seen before (i.e., considering the "Black Swans")

--Understanding the detailed mechanics of the investments in the portfolio, such as structured debt, convertible bonds and derivatives, etc.--and how extreme scenarios will manifest themselves in these investments

Only after these exposures have been identified can management make informed decisions about which to retain, hedge or avoid.

For a reinsurance buyer, these issues highlight the need to "underwrite" your reinsurer. Look beyond the credit ratings. It may not be possible to review all the workings of the reinsurer's internal risk management process, but consider how thoroughly the reinsurer underwrote your deal. Review their financial statements and analyst briefings--if they are involved in non-traditional investment activities, it may be a good thing, but make sure the risks are managed. In short, make sure your reinsurer will not be blindsided by exposures it did not know it had.

April 15, 2009

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