Burning issues

Christian Milton is vice-president, reinsurance officer, at American International Group (AIG). He is responsible for the management of the purchasing of reinsurance by all affiliates and subsidiaries of AIG, including the accounting, electronic data processing, dispute resolution, security and reinsurance relationships of the company.

AIG member companies serve commercial, institutional and individual customers through worldwide property and casualty and life insurance networks. In the US AIG is the largest underwriter of commercial and industrial insurance.

What is the major issue in the (re)insurance markets?

From our perspective, management of long-term, counter-party risk is at the forefront of what we in the industry have to deal with.

The reinsurance industry has a finite amount of capital, a lot of which has been severely depleted, particularly in the European experience. It is going to take a long time to build up that capital. From our perspective, the last thing we need is insecurity as a result of reinsurance failure.

How you manage that becomes very important to us. We are looking at it today with a view to minimising our credit risk and at the same time being able to generate capacity in order to write the business with our reinsurance partners.

How would you describe the impact of depleted capital on the sector?

I think you can say that the 1990s can be characterised as the years of glorious capital gains in investment return. But it hid a lot of sins in terms of underwriting. People didn't have to perform per se in the reinsurance world in order to achieve the bottom line objective as long as they had very good cash flow, they could invest it. This would mean they could make some capital gains and, using their balance sheet and cash, they could deliver what they believed to be an adequate return.

Now move past 2001. The investment return everyone expected has vanished.

The investment return as far as actual return on cash is 3-4%. Now the only way to really make a margin is with underwriting. Unless there is an underlying change in equities and investment returns, there has to be a much more pronounced underwriting return and most reinsurers haven't done that in 20 years.

They have lived off capital gains and investment income. Now they have to show real underwriting returns and that is going to be the difference as we move forward for the next three or four years.

And is this leading to a strategy of diversity?

In the world of credit, diversity is your best friend. But the problem in reinsurance is, when you look across the spectrum at how many people are out there, how much capital they are employing and the credit ratings, it actually becomes a worst nightmare.

In essence, the better credits have been able to raise new capital in tough times because of their internal management structure. So they have been able to find a landing in terms of continuing their business. The less credit worthy companies invariably go out of business. We can talk about termination clauses, credit triggers within reinsurance, but a lot of these tools have been in existence for the best part of 15 years. There is an automatic implosion for a bad credit, and it happens very quickly.

Does this mean security has become a more significant factor?

Within AIG, security has been a high profile issue for a long time. We were one of the first companies to institute a formal procedure for the approval of reinsurers within the company. We did that back in the late 1970s and we have been consistently refining it as our view becomes more educated over time. If you go and talk to anyone in the reinsurance market about AIG's security procedures they will tell you we are probably one of the toughest in the market place and have been for several years.

The rating agencies are still very important, in terms of how much bearing you might have in using reinsurance. We have a lot of collateral as far as a lot of our reinsurance is concerned. We can concentrate our reinsurance, effectively looking at the better credits. Whether it is the 'AAA' or the 'AA's', that is where our prime policy has probably been for the past 15 to 20 years. We were talking about diversity being a friend in credit and the worst enemy in the reinsurance industry; this is where it starts to show as far as reinsurance credit is concerned.

Can you explain how 'recycling' capital works as a strategy?

It seems, on a number of lines of business, there will come a time when it is possible to be reasonably comfortable in terms of what the bottom line result of the specific set of transactions are. It is then possible to capitalise it and 'net present value' it and therefore commute it back to the ceding company that becomes the beneficiary.

You have to think of reinsurance in terms of: are you looking for relief as far as losses are concerned or protection from losses; or are you looking for financial relief in terms of the balance sheet as far as reserve to surplus of capital is concerned? If you have sufficient capital, in many instances it is possible to commute it and bring it back into the P&L on the balance sheet and minimise the credit.

This achieves a couple of things. Number one, it minimises the cedants credit and gives the company a fixed return that everybody can agree upon.

For the reinsurer it does two things. First and foremost under the risk-based capital (RBC) rules, as soon as the reserves are taken back to the cedant company there is a need for less capital to support the reserves previously on the books. Therefore capital is automatically being freed up to write new business. The other impact is, if you think about a commutation in its broadest sense, it is like riding an unlimited stop-loss with no credit risk attached to it because you just go back to the original client.

How important is modelling?

Modelling is relevant to us in terms of being able to measure underlying risk volatility within our own company. Looking at all insurers who have natural catastrophe risk built into their portfolio, I don't think you can do a reasonable job of risk management without a model and so everybody is using a model. Even to the extent that it starts to give a floor on pricing, which is what happens when everybody is using the same model.

We use three models within AIG at this time. Renaissance Re, as an example, not only uses three models but they build some of their own models. And they blend some models. They have been able to achieve above average returns.

How has Renaissance Re used this modelling?

I don't think Ren Re has necessarily made arbitrage work for itself. I think the people at Renaissance Re have probably done a pretty spectacular job in terms of understanding how to use models to predict what they believe to be their sensitivity to losses. And they have done it, as it might be expressed, 'to their competitive advantage'. They understand the underlying models and they understand the volatility that is built into those models and to that extent it can then be used to arbitrage. I think in terms of making that a competitive strategy and making it compelling they have done an excellent job and have provided above average returns to some of their shareholders.

How is the necessary underwriting discipline achieved?

We all have a number of tools in terms of rating to exposure and how we think about long-term risk. Anyone who hasn't got those tools can't do the job.

We have to provide our shareholders with a return. We have a stated policy of growing our bottom line on consistent basis, year on year. We know we have to grow our earnings and if you can't get it from the investment side it has to come from the underwriting side of the house.

But I don't think it is a question of buying at the right price. It is a matter of looking at the gross margins before even starting to buy something.

Reinsurance has certain different values for us. Our job is to deliver risk capacity to the front end of our organisation so that we can sell product. If we overprice in the buying process we are in terrible shape at that point. If you buy reinsurance at an over-stated price, it can only be passed through to the front end and then we start to lose product sales.

Do you leverage your size to get better pricing?

I think we get some benefit, in the way we buy in that we buy a lot of individual facultative, one by one type risk so we get a match between what the reinsurer provides and what we are able to provide to our front-end clientele.

Reinsurers provide a whole slew of different services and in many respects a smaller company who has less visibility in the market place has more of a need for reinsurance expertise than AIG who has a huge database which is possibly able to do some things which the reinsurer can't. We probably have a bigger database than some of our reinsurers. The XYZ Mutual in Nebraska may only see a specific kind of claim come through the front door once every 20 years and therefore their experience in terms of how to handle that is much more limited and the reinsurer, with its much broader perspective, is able to give assistance.

For the smaller companies, what happens is they have a need from time to time to issue a big limit and they need to go to a reinsurer to get the pricing. Some of the larger reinsurers use the smaller companies as part of their distribution network.

Looking at specific risk, how is the need for terrorism cover being addressed?

In America the industry is going to have to face the facts from the reinsurance standpoint; the back stop that is currently being provided by Tria has not yet been supplemented by commercial reinsurance.

Meaningful change in Washington invariably means that you have to have a grass roots movement rather than just the insurance industry saying we need something.

And the workers compensation market is another significant issue in the US?

The government has just signed a bill in California for premiums. A lot of risks that occur in the US are propagated by legislators. As such there is a social cost any time a benefit is given out by legislation when the underlying insurance has to be altered.

In many respects I think the insurance industry takes the brunt of that along with the reinsurance industry, in dealing with the volatility. For the reinsurer it can be a much more problematic issue because there is an inflationary effect on deductibles and it essentially increases their loss cost by multiples as opposed to a percentage.

How do you view the regulatory position in the US?

We have a very active set of regulators in the US, under the International Association of Insurance Commissioners. In many respects they are trying to get an umbrella of regulation that applies state by state - not unlike what happens in Europe under the EU.

We have a regulation system which, if you look at it from an accounting standpoint, is relatively transparent and when we say transparent, it is transparent in the public domain which is more so than in Europe. Also, every three years we have a tri-annual examination.

The state regulation is to ensure solvency and to approve or disapprove of the products and pricing. They want to be sure that the products being delivered to their consumers are priced effectively and have terms and conditions that they agree with.

CV

1966-1967: Claims broker at Stewart Smith & Co, London

1967-1968: Reinsurance claims broker at De Fable Halsey & Co, London

1968-1972: Reinsurance claims manager, Henry Head & Co, London

1972-1974: Excess of loss underwriter at American International Reinsurance Company, Bermuda

1975-1977: Excess of loss underwriter and Assistant vice president, American International Reinsurance Company, Bermuda

1977- 1978: Assistant vice president - Chief non marine reinsurance underwriter at American International Underwriters, New York Vice president, American International Underwriters, Bermuda

1978-1980: Assistant vice president - reinsurance manager at National Union Fire Insurance Company, New York

1980-1985: Assistant vice president - reinsurance manager, American International Group, New York

1985 -present: Vice president - reinsurance officer at American International Group, New York.