Yesterday we discussed about RSM 1 which is based on Premium. Today, we discuss about RSM 2 which is based on Claims.
Required Solvency Margin 2 is based on net incurred claims, which is the higher of the Gross Incurred Claims multiplied by a Factor B and the Net Incurred Claims.
Let’s assume a reinsured has written a small Aviation portfolio with Gross Premium of USD 1 million. Let’s assume 1% is retention and 99% is cession. Let’s also assume in that year, one flight crashed and there was a claim of USD 200 million.
Factor B for Aviation line of business is 0.9
Gross claims multiplied by factor B = USD 200 million * 0.9 = USD 180 million.
Net Claims = USD 200 million * 1% = USD 2 million.
Higher of the two is USD 180 million and hence this figure will be considered for RSM 2. This will also be higher of RSM 1 and RSM 2 and hence for solvency requirement, this is the figure that will be considered.
As we can notice, even though the risk is heavily reinsured, the benefit of reinsurance is very minimal.
As Hari Radhakrishnan was mentioning is yesterday’s comments, this would mean infusion of additional capital. And next year, if it was a claims free year, there will be excess capital.
In a highly regulated industry like Insurance, bringing in capital is easy, taking out capital is difficult.
This is the reason why good conservative insurers never write highly volatile lines of business in the initial years. They only think of such business once they have grown large enough.
I was reminded of an incident in a direct insurer I worked with. The Commercial Director was an Englishman. I was planning to discuss with him about underwriting acceptance of Haldia Petrochemicals. The moment I opened my mouth saying Haldia Petrochemicals, the Director stopped me saying:
“Petrochemicals is our declined list. Why are we wasting our time discussing about what is in our declined list?”
An important lesson for me- Underwriting manual is created to be followed without questioning. Not to look at reasons for deviating from underwriting manual.
Coming back to the advantages and disadvantages of Formula based Solvency, Hari Radhakrishnan had beautifully summarized in his comments and hence not repeating the same. Those interested may read his comments to yesterday’s blog.
Formula based Solvency calculation is unfortunately not differentiating whether a reinsured has placed his business with a strong reinsurer or a weak reinsurer.
Blog by Atmaram Cheruvu
