Jurgen Petzold considers the effects of target-oriented management on facultative reinsurance.
Before assessing how management affects the performance of an international facultative reinsurance book, one must understand the underlying nature of the business itself.
Each facultative reinsurance activity starts with an analysis of the client's needs for reinsurance. The client usually is an insurer – the cedant – though it does not really matter if this business is being offered directly to the facultative reinsurer or if the risk is being placed by international reinsurance brokers on a worldwide basis. The insurer or its broker prepares a detailed facultative offer including technical and insurance data on a single risk to be placed, following which the underwriter carries out a detailed risk offer examination including the aggregation assessments and other, per risk, negotiations such as risk type and quality, pricing, loss experience and loss prevention measures taken. The underwriting decision follows – either the acceptance or rejection of the facultative offer – and is sent to either the insurer or its broker.
In fact, control activities for international facultative reinsurance business start outside this process and extend beyond the underwriter's decision to accept or decline the risk; control is manifested during the settlement of the account, technical booking and premium payment, through to the processing of claims.
International facultative business can be characterised as being potentially highly volatile and instable. Because of this fluctuation, the portfolio results can go in both directions – profit or loss – and an active result management system is therefore an important challenge for a section controller in facultative business.
As well as the fundamental nature of risks and the geographical risk regions included, the highly unstable nature of a facultative reinsurance portfolio also relates to the timing of losses. In addition, the variety of written risks make a high demand on the qualifications, the underwriting know-how and the skills of facultative underwriters, who judge these risks and integrate them into their existing portfolio. The ‘slightly' lesser premium cover compared to treaty reinsurance is another special feature of facultative portfolios.
Thus, there are four main characteristics which are relevant in the effective management of international facultative reinsurance:
This proves the need for an effective and efficient control strategy for facultative reinsurance. At least on a gross basis (before excess of loss protection and single retrocessions), this highly volatile and hardly predictable – but still profit-promising – sector of international reinsurance business has been judged as a service business by most of the professional reinsurers. In recent years, however, many professional international reinsurance companies have deviated from this philosophy. These companies run their facultative reinsurance business increasingly as a strategic business segment or as a results-liable profit centre, which has to aim for middle- or long-term profit and accomplish positive profit and contribution margins, as well as minimum results and equity margins.
These business requirements create the need for appropriate and effective strategic, tactical and operative planning and management. In these times of ever-increasing competition, mounting business concentrations caused by mergers and acquisitions, and decreasing profit margins from increasing internal costs and risk costs in combination with falling premium levels in international soft markets, it becomes even more important to manage the facultative reinsurance business, particularly if it is to survive as an independent business segment or profit centre.
In this connection, ‘management' means the control of active facultative reinsurance business. This means the manager's job, which is supported by the controller, and controlling is not only a retrospective review or supervision of former business activities and results, but, rather, foresighted planning – more precisely, active management and control. It can be compared to a vehicle driver who looks not only into the rear view mirror but also watches the front and the sides in order to anticipate what is coming up.
If an organisation is viewing facultative reinsurance as an independent strategic business segment, or at least as a results-liable profit centre, the facultative function has no choice but to make profits for the company. Against this background, the limitation of the function being a pure ‘service provider' for other business fields of the reinsurance company is being rejected.
A decentralised organisation forms the basis of the organisational structure for facultative business, meaning it is written on the spot, i.e. locally, in markets where it is advantageous and profitable. At this point, it is worth remembering a remark made by the CEO of one of the world's largest reinsurance companies, that “facultative premium has to be earned locally”.
Mostly control functions are found at the highest management level and clarify what status the function management and controlling have in a company's structure of international and decentralised operating facultative reinsurance, and what its status should be. In most cases, control is established in the hierarchical level of the business centres. The basic organisational decisions indicate that control has to mean much more than just using a review process; rather, it also includes the target-orientated, forward-looking management of the international facultative portfolio.
A further basic assumption exists; that the business section for facultative reinsurance is being controlled and directed by the principle of ‘management by objectives'. That means that the appropriate business sections within the mutually agreed and defined targets act independently and manage their own market sectors (regions and/or business segments). That is one of the reasons why facultative reinsurance needs entrepreneurs on all levels of activity, though particularly at the management and controlling level.
Against this background, the management goal for international facultative reinsurance defines itself as risk-impartial target control determined by adequate return on equity and margins.
At the centre of facultative reinsurance management is the optimum profit capacity allocation, which leads to simultaneous optimising of technical and financial results of the international facultative portfolio. Being subject to such a complex target, this capacity allocation needs to be supported by an actively involved management process, which is mutually recognised by the management, the control, and the local as well as the centrally operating underwriter.
The control process can only work in the presence of efficient IT support on every activity level.
Classical management duties include procurement, analysis, processing and provision of decision-making information, providing the platform from which to make decisions. Furthermore, the performance of analysis duties comes into play here. Management support for planning and controlling the worldwide business activities in the facultative sector, as well as the co-ordination between all company levels and departments involved, are even more classical management duties. Regular turnover, margin and result assessments, portfolio analysis, aggregate definitions and the suchlike are typical classical management tasks. In this connection, the operative and controlling character of the task is predominant in the control activities. The same applies to the performance of debt/credit comparisons and appropriate analyses. Further traditional duties exist in the acquisition and further development of reporting, key indicating and forecasting systems and their integration into the overlapping management system of the initial reinsurance company. Finally, the support function within the scope of adapting IT to the technical demands of control follows as one of the classical management tasks.
In most international facultative reinsurance departments, these traditional management tasks generally are taken care of – perhaps even too well dealt with and therefore sub-optimal, resulting in ‘control overkill'. Only the area of IT support has often been described as in need of improvement. A significantly different situation reveals itself when looking at the modern control/management assignments in international facultative reinsurance. Firstly, the modern control assignments in international facultative reinsurance include management support and consultation for managing the worldwide facultative activities. Within this context the controller – or, better, the control manager – may be referred to as an internal consultant who supports the company within the framework of business management.
An additional modern and progressive management tack is the acquisition, implementation and further development of financial control systems. The development of such controlling systems is not confined to IT systems and should meet international demands, such as US GAAP or International Accounting Standards.
The specific management of target-orientated diversification of the portfolio, aiming for volatility smoothing and results compensation, is the main objective for international facultative reinsurance. The collaboration of the control manager is one of the most important assignments in the framework of management functions to define and determine objectives and targets for the facultative reinsurance underwriters. These objectives and targets form the starting point for capacity control to try and achieve an optimal target and margin, in the form of return on capital. To prepare the management of objectives, targets and margins, a modified balanced score card approach as well as a key indicating system present themselves as ‘classical samples'. Despite intensive efforts in the past, explicit top key indicators could hardly be assigned concerning return on equity and capital and/or marginal costs. The risk aspect points out that facultative underwriting exclusively aimed at top key indicators such as cash flow is as impractical as a basic shareholder value-orientated underwriting, which is also very difficult, if not impossible. Also, a mainly cost-minimising and ‘a loss to no service' approach seems to lead to deflated results compared with modern management approaches.
Compared to traditional management roles, the modern control and management duties in international facultative reinsurance are still being accepted very cautiously. It has to be assumed that a stronger focus on these management duties can provide considerable success potentials. Generally, this happens without taking on additional or higher technical insurance and financial risks.
The following questions must be addressed by the controlling management:
In the framework of investigations, analyses and prognoses of external influences, the question arises whether strategic radar is already being used and to what extent active future management is being performed for the international facultative reinsurance.This responsibility, which deals with structured and periodical observation and the investigation of the business's front line exposure, belongs to the main duties of modern management of international facultative reinsurance.
The use of the balanced score card method in combination with the classical key indicator approach creates an imposing catalogue of key indicators, from which the individual performance indicators must be chosen and derived. With regard to the actual control conditions in the international facultative reinsurance sector, the following conclusions can be made:
Within the framework of the controlling conversion for the international facultative reinsurance as well as in other enterprises, the according cost-benefit aspect always has to be considered and optimised. Not everything that is theoretically possible is economically practical and profitable.
In order to secure the best adaptation of management duties, at least one section controller has to be in charge of the facultative business in the head office. This function should ideally be perceived as a main function beyond the regular underwriting and administration function. Depending on the importance of the controlling function which the management decides, the facultative controller is placed beside the reporting line between the qualified executive board member for facultative business and the general manager of the facultative department, or as a main function in the reporting line between the general manager, the associate director and the subordinate associate directors. The first variation, close to the executive board member, shows that the controlling manager is entrusted with the operational and strategic functions by being involved in the strategic development and implementation. The second variation shows a mainly operative alignment of management duties – almost exclusively referring to expense, results, cost and performance and results measurements.
Within the framework of international control in a decentralised facultative organisation, besides being a section controller the function of the local controller is seen in all business units and local offices. The extent of this task, which may be a full- or part-time role, depends upon the size and the volume of the appropriate business unit. Furthermore, an efficient and profit-advantageous controlling organisation for international facultative reinsurance needs a controlling commissioner in all underwriting centres and marketing centres, to promote the idea of self-control.
At the same time, a minimum of a quarterly forecasting system is also necessary, as well as an annual planning and controlling calendar. Additionally the following requirements need to be fulfilled:
Information technology plays a vital role in the support of facultative business. Its main features are:
As a class of business, facultative reinsurance is becoming more and more of a strategic business unit, which has to contribute to the company's returns. Management of the international facultative reinsurance function will always be a tailored product. It is complex and evolutionary, and as such it is permanently being developed – probably the most interesting challenge of the business. Besides the operational aspects, strategic issues must be taken into consideration.
The basic idea is to control the facultative reinsurance capacity, as well as the investment capital of the facultative business, in order to maximise both technical and economic results. Judicious use of management controls for international facultative business can lead to 20% or more in increased returns, without taking any additional risk.
In recent years, the need for highly sophisticated management controls for the business has grown substantially. This relatively new way of running international facultative reinsurance business requires a strong and powerful management support, as well as motivated and actively involved employees leading the business to long-term success.