The Transfer of Major Latin American Risks to the International Reinsurance MarketRegulation, customs, examples and models April 2023
Given the large amount of capital required for the operation of a reinsurance company, most reinsurers are organizations based in “developed” countries. Currently, the largest reinsurers in terms of premiums and global business are based in the United States, Germany, Switzerland, the United Kingdom, France and Spain.
Because insurance is a strategic industry in terms of the insurance market itself, as well as a generator of international capital, the governments of many countries promote the development of reinsurers with local capital. But there are some risks that private reinsurers might prefer not to assume, such as coverage for terrorism and natural disasters, which justifies governmental intervention to protect the public interest. Additionally, the reinsurance industry is exposed to capital profitability cycles, and sometimes experiences large fluctuations in claim rates, which produce changes in the cost and the type of coverage offered, and which may be counterproductive for the development of the insurance industry.
The government’s involvement in the Latin American reinsurance markets differs depending on local regulations. First, a government often limits the possibility of seeking coverage abroad for any interest that can be insured in the local jurisdiction. For example, in Argentina, Law No. 12,988 prohibits it, which implies that local insurers often only retain a minimum portion of any “major risks,” usually less than 1%. It should be noted that these “major risks” are often on the account of the national governments of the countries in the region, which implies that the assigned local insurer is often an insurer that belongs to the national government of the country where the policy holder is located. In the above case, in Argentina, this insurer is Nación Seguros S.A, and all the insurance policies of national public entities must be taken out through this company.
On the other hand, regulations in Latin American countries generally promote the participation of both public and private insurers and the development of reinsurers with local capital. For example, in Brazil, in addition to the Local and Admitted Reinsurers, there are also Occasional Reinsurers. Under this category, the ceding companies must demonstrate that the local market supply is insufficient to cover the specific risk.
Other countries in the region take a different approach to the promotion of reinsurers with local capital. Chile, for example, establishes requirements for foreign reinsurance entities, such as being rated by at least two internationally recognized agencies, as determined by the superintendence, with a credit rating of at least BBB or its equivalent, and having appointed a representative in the country. The latter requirement may be waived if the reinsurer is registered with the superintendence.
Uses and Customs in the Facultative Placement of Major Risks in Latin America
The major risks of each country in the region are generally distributed through the facultative modality in the international reinsurance market through the main brokers, who have direct access to the main European reinsurers, to the “Lloyd’s Market” and to other international reinsurers.
The reason these risks are placed under the facultative modality rather than through an automatic reinsurance contract between an insurance company and a reinsurer is due to the large insured amounts and their particular characteristics, which means that they do not fit into the standard parameters of an automatic contract between the parties. It is important to point out that given the large insured amounts of these risks, the amount retained by the Latin American insurers is generally very low, and they are often taken only for the purpose of complying with applicable regulations on this matter.
The local reinsurers incorporated in several Latin American countries also usually retain only very small amounts to comply with applicable regulations. In this context, local reinsurers usually retain only a nominal amount of the risk and cede the rest through retrocession to the large international reinsurers. Instead, in some countries in the region, as in the case of Argentina, major risks can be fully placed through international reinsurers, given that there is no regulatory requirement for the participation of a local reinsurer in placing the risk. Consequently, in Argentina, facultative risks in amounts equal to or above $35 million can be fully placed through admitted reinsurers, which are those that have decided not to incorporate as local reinsurers. The main international reinsurers operate in Argentina under this modality.
Major Risks in the International Reinsurance Market in Latin American, by Country
In Argentina, risks are highly concentrated in the surrounding areas of Buenos Aires, Rosario (related to sugar, flour, meat products, metallurgy, chemicals, etc.) and Córdoba (mainly automotive). In the energy sector, the main risks involve oil companies, hydroelectric power stations and, increasingly, renewable energy facilities. Air transportation is another industry with large demand for facultative capacity, including Aerolíneas Argentinas, a national government company.
In Brazil, the economy is concentrated in São Paulo, Río de Janeiro and Belo Horizonte, which are highly industrialized areas. The main risks are associated with oil and gas, mining, banking, energy and telecommunications. However, there is also large demand associated with automobiles, steel, petrochemicals, computers, aircraft and durable consumer goods.
In Chile, the largest catastrophic risk is earthquakes, particularly in Santiago, where the values are highly concentrated. The main industries include energy, steel, mining, fishing and agriculture. The government does not usually insure its properties, such as ministries and hospitals.
In Colombia, the main risks are distributed in the cities of Bogotá, Medellín, Cali, Barranquilla, Bucaramanga and Cartagena. The most important sectors include oil, telecommunications, public utilities and retailing. These accounts and other major risks require the support of both automatic contracts and facultative coverage provided by international reinsurers.
In Ecuador, the main industries include oil (refining and related), energy, beverages, tires and cement. There are also risks associated with agriculture, such as sugar, coffee, cacao, cotton and textiles. New major facultative risks include the airport and metro system of Quito (which uses all-risk construction coverage).
In Paraguay, industry is small in size and is concentrated in Asunción and its surrounding areas. Even though Villeta and Pilar are important production areas, they do not pose significant issues related to the accumulation of insured risks. The hydroelectric systems of Itaipú and Yacyretá are some of the major risks placed through facultative reinsurance. In other cases, local co-insurance is used.
Similarly, Uruguay does not have large risk concentrations, and most operations are managed through co-insurance between local companies. Major fire risks are related to items such as cellulose, paper, telecommunications, electricity, food products, refining, pipelines and cement.
Actuarial Models to Determine Reinsurance Rates of Major Facultative Risks
Insurance plays a central role in the development of the industries that drive the various Latin American countries and given that the major risks of these industries are for the most part ceded to the international reinsurance market (with a small amount retained by local companies), reinsurance fulfills the function of stabilizing the economic and financial results, as a source of capital.
Public and private companies and local insurers and reinsurers must decide which risks to transfer to the international market, and which ones they should retain. For the risks they decide to transfer, they must decide which part to cede and which part to retain, by defining limits/sub-limits and deductibles/concessions.
To make decisions, these companies use technical-actuarial analysis to determine the optimal levels of retention and the reinsurance premiums for these retention levels. The models include those recommended by the different actuarial organizations, such as SOA, CAS and IFOA.
In developing these models for strategic decision-making, a claim distribution function must be established, which is usually defined by actuaries who interact with professionals who are experts in a specific industry (engineers, meteorologists, surveyors), taking into consideration the empirical experience and all the variables that affect claims.
The suggested technique for finding results is the simulation, which enables resolving a complex model with a series of correlated random variables. The modeling process requires selecting a statistical distribution (Log-Normal, Transformed Gamma, Burr, etc.) that best fits the phenomenon to be studied. The distribution and the parameters must be periodically tested through goodness of fit testing, to confirm whether they best fit the phenomenon being assessed. For example, as the size of the portfolio increases, considering the “Law of Big Numbers,” the standard deviation of the distribution decreases, which may require recalibration of the parameters.
The capitalization level of a local insurer or reinsurer is one of the main variables related to ceding risks. For industries with a limited and predictable claims history, the required capital (and therefore the amount of risk ceded to the international reinsurance market) could be lower than for risks with a more volatile claims history. The company will have to define a target capital, depending on its level of risk aversion. For example, it may decide that its target is to have a capitalization level that, with 99% probability, is sufficient to cover an unfavorable claim event.
Once the claims distribution function is established, the entity’s own capital requirements to achieve that target could be higher or lower, depending on the facultative placement rates and the risk retention level. Therefore, the decisions related to reinsurance will depend on the level of capital the company has available to further its growth process.
For example, in the case of a local insurer or reinsurer, its capital could be equivalent to 150% of its premiums. However, considering its risk aversion level and the claims distribution, its target could be to have capital equivalent to 200% of its premiums. In this situation, reinsurance represents a solution as a source of capital to finance the company’s activities. Establishing an adequate ceding arrangement through reinsurance can reduce the amount of its own capital the company actually needs to have available for its operation.
Several methods can be used to determine the capital required for the company’s activities, of which the most frequently used is the Tail Value at Risk (TVAR). The TVAR (Alpha) varies depending on the distribution and the selected risk parameters, as well as on the selected reinsurance program. This enables an insurer to calculate different values for different levels of retention.
The TVAR values (99%) and Expected Claims Rates for an insurer that used this model for strategic decision-making are shown in Table 1.
|TVAR (99%)||Expected Loss Ratio|
|Limit 60% xs Priority 95%||1.61||33.60%||1.90%|
|Limit 60% xs Priority 75%||1.48||31.80%||3.70%|
In this manner, taking into consideration a) its risk aversion level, b) its current capital level and c) its capacity to support growth in production, the company decided to take out a stop loss program, with a 60% limit and a priority of 75%.
Additionally, using the same model, this company determined the cost of different reinsurance programs and used this analysis to present its arguments before a panel of reinsurers, achieving in this manner a significant reduction during its contract renewals.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
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