Ripple Effect

Study guide: Exam 6C

A Ripple Effect is a second-order consequence that follows from an adverse scenario, beyond its direct financial impact. FCT requires the Appointed Actuary to model them: a scenario examined only for its immediate effect understates its severity, sometimes by a wide margin.

• Typical ripples following a catastrophe: reinstatement premium payable immediately; reinsurance renewal at much higher cost or reduced capacity; a rating downgrade; higher borrowing costs and impaired access to capital markets; reduced new business as the rating falls; and, if the event affected the insurer's own region, operational disruption.
• Ripples following reserve deterioration: loss of regulatory and market confidence; a Rating Agency downgrade; the need to re-price, which loses business; increased OSFI scrutiny and possible restrictions on dividends and growth; and — since inadequate reserves usually mean inadequate rates — continued losses on business still being written.
• Ripples following an investment loss: reduced Capital Available, which raises the cost of writing business; forced asset sales realising further losses; and a market risk profile that may worsen if the remaining portfolio is less liquid.
• The compounding is the point. A \$50 million catastrophe that triggers a downgrade, a 30\% reinsurance cost increase and a 10\% loss of business is not a \$50 million event. Modelling only the direct loss produces a scenario the insurer comfortably survives on paper and would not survive in fact.
• Management actions are the counterpart. FCT requires both: the ripples that worsen the scenario, and the realistic responses that mitigate it. The discipline is to be equally honest about both — and to recognise that some actions available in normal conditions (raising capital, buying reinsurance) are unavailable in the scenario that created the need.
• The most commonly omitted ripple is the feedback into pricing: the events that damage capital usually also mean the business currently being written is underpriced.

A Catastrophe With and Without Ripples An insurer suffers a \$60 million net catastrophe loss. Capital available before the event is \$340 million and the base solvency buffer is \$200 million.

Model the effect with direct impact only, then with ripple effects: reinstatement premium \$8 million; reinsurance renewal cost rising \$12 million annually; a downgrade causing a 9\% loss of commercial business worth \$14 million of annual underwriting contribution; and borrowing costs rising \$3 million annually.

Answer Direct impact only, after tax at 27\%:

\begin{align*}
\text{Capital available} &= \$340\text{M} - 0.73(\$60\text{M}) \\
&= \$296.2\text{M} \\[4pt]
\text{MCT} &= \frac{\$296.2\text{M}}{\$200\text{M}} = 148\%
\end{align*}

Marginally below the supervisory target. A board shown this number would find it uncomfortable but manageable.

With ripple effects. Year 1 adds the reinstatement premium; the ongoing items affect year 2 onward:

\begin{align*}
\text{Year 1} &= \$340\text{M} - 0.73(\$60\text{M} + \$8\text{M}) \\
&= \$290.4\text{M} \quad (145\%) \\[6pt]
\text{Year 2 drag} &= 0.73(\$12\text{M} + \$14\text{M} + \$3\text{M}) \\
&= \$21.2\text{M} \\[4pt]
\text{Year 2} &= \$290.4\text{M} - \$21.2\text{M} \\
&= \$269.2\text{M} \quad (135\%) \\[6pt]
\text{Year 3} &= \$248\text{M} \quad (124\%)
\end{align*}

The difference is the whole point. The direct-impact view shows a one-time dip to 148\% followed by recovery. The ripple view shows a continuing decline to 124\% over three years, because the event permanently raised the cost of doing business and permanently reduced the business being done.

What changes as a result. The direct view suggests no action is needed. The ripple view requires a capital plan, and it identifies the actionable items: the reinsurance cost increase and the downgrade-driven business loss are both larger than the reinstatement premium, and both are addressable — by pre-negotiating multi-year reinsurance terms, and by holding a higher internal target so that a \$60 million event does not threaten the rating in the first place.