Catastrophe Reinsurance Retention and the Cost of Capital
Harbor Point Insurance has $100 million of surplus and writes $150 million of coastal property premium. Its 1-in-100 gross catastrophe PML is $100 million. It buys a program with a $10 million retention and a $30 million layer excess of $10 million, paying $8 million; expected recoveries are $6 million, and net PML is $60 million. The rating agency requires capital equal to net PML plus $20 million, so required capital is $80 million. An alternative is a $20 million retention and $20 million excess of $20 million, costing $4 million, with expected recoveries of $3 million and net PML of $80 million. The CFO wants to save $4 million of premium and argues the company still has $100 million of surplus.
1. Calculate the net expected cost of each reinsurance program, including a 10% cost of capital charge on required capital, and recommend.
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For the current program, net expected reinsurance cost = premium - expected recoveries = $8 million - $6 million = $2 million. Required capital is $60 million net PML + $20 million = $80 million, so the capital charge at 10% is $8 million. Total economic cost = $2 million + $8 million = $10 million. For the higher-retention alternative, net expected reinsurance cost = $4 million - $3 million = $1 million. Required capital is $80 million + $20 million = $100 million, so the capital charge is $10 million. Total economic cost = $1 million + $10 million = $11 million. The current program is cheaper by $1 million on this basis, so the recommendation is to keep the $10 million retention unless qualitative factors override. The CFO's $4 million premium saving is real but is more than offset by $3 million of lost expected recoveries and a $2 million increase in the capital charge.
2. Under what conditions would raising the retention be justified?
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Raising retention would be justified if the current program's net expected cost rises above the alternative's. For example, if expected recoveries on the current program fell from $6 million to $3 million, its net expected cost would become $8 million - $3 million = $5 million, plus the $8 million capital charge, or $13 million, versus $11 million for the alternative; the higher retention would then be cheaper. Other justifications include a lower cost of capital, available surplus that exceeds the rating agency requirement with a comfortable cushion, a reinsurer credit deterioration that makes recoveries less certain, or a change in the gross PML. The decision should also consider risk tolerance, earnings volatility, franchise value, and the possibility that the rating agency assigns a higher capital charge to the larger net PML than the simple 10% proxy. The quantitative comparison should be refreshed with current pricing and exposure data.
3. What qualitative factors could override the quantitative result?
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Several factors could override the $1 million quantitative advantage of the current program. Reinsurer counterparty risk is important: if the reinsurer is weakly rated, expected recoveries should be haircut for default risk, and collateral or a replacement panel may be needed. Contract terms matter, including reinstatement provisions, hours clauses, exclusions, and whether the layer truly attaches for the company's peril mix. The rating agency may penalize earnings volatility or require more capital than the simple formula suggests. Management may also value the larger program for franchise protection, broker relationships, and access to capacity after a catastrophe. Conversely, if the company has ample surplus and wants to retain more risk to improve long-term margin, the higher retention may be strategically sound. The board should see both the expected-cost calculation and these qualitative factors, with a documented risk appetite.