Catastrophe Treaty Retention Trade-off
Harbor Point Specialty writes $120 million of commercial property premium, concentrated in Gulf and Atlantic coastal states. Its catastrophe treaty is $45 million excess of $5 million and costs $4.8 million. The reinsurer offers the same terms or an alternative $40 million excess of $10 million for $2.9 million, a saving of $1.9 million. The internal model puts the 1-in-100 net PML at $38 million under the current program and $34 million under the higher retention. The rating agency requires the 1-in-100 net PML to stay below $40 million and charges capital at 8% of required capital. The CFO favors the saving to improve a 97% combined ratio; the CRO notes $6 million of letters of credit support the current retention and that cat bond issuance would take 90 days. Renewal is due in 30 days.
1. Quantify the economic trade-off between the two treaty options, including capital and risk transfer, and state what additional information you would require.
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The premium saving is $1.9m. The higher retention increases the 1-in-100 net PML by $4m, from $38m to $34m, but remains below the $40m rating-agency limit. At an 8% capital charge, the extra $4m of retained risk costs about $320,000 in capital, so on a simple capital-cost basis the $1.9m saving dominates. However, the comparison is incomplete because the company also bears the expected loss and volatility in the $5m–$10m layer. I would require the modeled expected loss and 1-in-250 tail for that layer, the cost of the $6m letters of credit, and the probability of more than one large event in a year. If the expected loss in the layer is, say, $0.9m and the tail is fat, the net economic advantage shrinks materially. The decision should compare risk-adjusted return on capital, not just premium saved.
2. Recommend a renewal decision and the conditions under which it should be implemented.
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Recommend accepting the higher retention only with conditions, because the capital and PML tests pass but liquidity and tail risk are not fully demonstrated. Conditions should include: maintain at least $10m of immediately available liquidity or committed facilities to fund the $10m retention; obtain the layer's expected loss and 1-in-250 PML; confirm the rating agency treats the $34m net PML as compliant; and retain a 90-day option to place a cat bond or aggregate stop-loss if the tail proves unacceptable. The $1.9m saving should not be booked as underwriting profit until the risk-adjusted analysis is complete. If the $5m–$10m layer has an expected loss above roughly $1.5m or the liquidity cannot be committed, keep the current treaty. This is a capital-allocation decision, not a purchasing decision.
3. What operational readiness steps are needed before operating with a $10 million retention?
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The company needs a claims surge plan that can handle a large event without waiting for reinsurer authorization, including pre-agreed adjuster capacity, a delegated authority matrix, and a cash-call procedure for the first $10m. It should pre-fund or confirm the $6m of letters of credit and test the drawdown process. Finance should model a stress case in which a 1-in-100 event occurs early in the year, because premium income may not yet cover the retention. Underwriting should tighten accumulation controls in coastal zones and monitor aggregation by CRESTA zone. Finally, the board should receive a written explanation of why the higher retention is acceptable and what triggers a return to the lower retention.