Assessing the appropriate level of free reserves – the at-most “one-in-ten” chance principle

Standard Club’s CFO Nick Jelley has written a bulletin on the club’s capital management methodology, particularly the assessment of an appropriate level of free reserves.

Jelly noted that all P&I clubs needed free reserves to protect members against shocks, but how large should these reserves be?

Free reserves were measured as the surplus of the club’s assets (investments, cash, reinsurance recoverables, premiums due) over its liabilities (principally outstanding claims provisions). Additional sources of capital could be used to top up the level of free reserves, such as the potential for clubs to make unbudgeted supplementary calls, although he noted that the Standard Club had not had to make an extra call for 25 years.

Jelley said that providing members with first-class financial security was one of The Standard Club’s four strategic objectives, and this included holding free reserves large enough to cushion members from paying extra calls to cover shock claims or losses.

In setting the level for its free reserves, the club needed also to consider its regulatory and rating requirements.

The appropriate level of its free reserves enabled the Club to:

        minimize the risk of making extra calls

        continue to benefit from its ‘A’ rating from Standard & Poor’s

        comply with financial regulations

The Standard Club’s free reserves were designed to provide protection to members against a financial loss that might happen in the future. Strong free reserves also helped  ensure pricing stability for members in the long term.

Calculating the anticipated financial risk required complex modelling of future claims, planned reinsurance and pooling arrangements, proposed investment strategy and expected overhead costs.

Jelley said that the club had developed and maintains internal actuarial model to estimate the probability of different levels of profit or loss occurring in the coming year and how this would affect the free reserves. The model inputs included the business plan for the next three years, expected volatility in investment markets, variability in the number and severity of large claims, variability in premium rates and vessel numbers, and the potential for claims inflation to rise or fall.

The model outputs allowed the club to understand the effect of future financial risks on profit, loss and free reserves, said Jelley. It was also used to calculate the probability of specific outcomes.

In practice, the biggest sources of financial risk – and therefore risk to the free reserves – were the number of large Pool claims on the payment side, and returns on higher yielding but potentially more volatile investments such as equities.

The Standard Club’s free reserves had to meet the minimum levels required by insurance regulators. 90% of the club’s P&I business was reinsured to Standard Re (the club’s captive Bermudian reinsurer) from the club’s operating subsidiaries in the UK and Singapore. This enabled the group to concentrate risk retention in one entity, thereby providing more effective capital management and optimizing investment opportunities. The subsidiaries must comply with local regulatory requirements, but the club’s main regulator was the Bermuda Monetary Authority (BMA). The free reserves required by the BMA’s ‘solvency capital requirement’ (BSCR) were calculated according to a standard formula which included premium volume, value of claims reserves and exposure to different categories of investment risk and reinsurance credit risk.

The club performed a free reserve calculation tailored to its own risk profile based on a 1-in-200 year worst-case outcome, generally known as an ‘own risk and solvency assessment’ (ORSA). The club used its internal model to calculate this figure, which it refers to as ‘ORSA capital’. If the club’s free reserves were to drop below the ORSA capital level, it was “highly likely that the club would need to make extra calls on members to maintain financial stability and to meet regulatory expectations”.

The Standard Club’s free reserves were a key metric used by credit-rating agencies to assess the club’s financial strength. The main agency for rating P&I clubs was currently Standard & Poor’s (S&P). The club’s ‘A’ (strong) financial strength rating supported members in meeting their own minimum insurance security objectives, ensured the club’s guarantees for members were readily accepted around the world and helped the Club to get the best deals in reinsurance and other key services.

The most important component of the rating was the level of free reserves compared with the risk taken, which S&P calls ‘capital adequacy’. S&P calculated this using factors such as planned premium volume, size of claims reserve and nature of investments.

Jelley noted that, unlike larger global insurers, P&I clubs tended to be limited in their ratings, because of their relatively small size, their lack of diversity and therefore higher underwriting risk. To achieve and keep an ‘A’ financial strength rating, S&P therefore looked for an ‘extremely strong’ capital adequacy rating and a significantly higher level of free reserves than was required from a regulatory capital perspective.

If the free reserves were to drop below the S&P capital adequacy level, it could put downward pressure on the club’s S&P ‘A’ financial strength rating.

The Standard Club’s free reserves needed to reflect the boundaries set by the club’s board for its risk appetite. The club’s board regularly reviewed the overall risks taken by the club, including risks from activities other than its core mutual P&I business – such as equity investments, The Standard Syndicate at Lloyd’s and fixed-premium insurance products. The club’s internal model was the primary tool used to measure this.

The club could control risks in several ways. To ensure consistency in decision-making, the board had risk-appetite statements which set the boundaries for each risk.

The club’s capacity to take risk was guided by its objectives as a mutual P&I insurer controlled by and operating for the benefit of its members. The board had therefore set its overall risk appetite in terms of the risk that it might have to make extra calls on members.

The club’s main risk appetite requirement with respect to the minimum amount of free reserves was to avoid risks that would lead to a more than a one-in-ten chance that the free reserves would fall to a level that would require the club to make a supplementary call. In practice, the club held free reserves considerably above this level, partly in order to meet rating agency requirements, and partly to maintain a surplus over this one-in-ten board tolerance. The chance of an extra call was significantly less than one in ten.

The club also used its internal model to assess the probability that free reserves could fall below the level necessary to support the club’s ‘A’ financial strength rating.

This allowed the board to make an informed assessment of whether the club’s free reserves were too high and, if so, whether there was enough surplus to give money back to members.

As a guideline, Jelley said that the board would view a cushion that suggested a less than one-in-ten chance that capital could fall below the level required to support the club’s ‘A’ financial rating as more than sufficient. In these circumstances, the board would be likely to consider a distribution of this surplus.

Jelley concluded that Standard Club was very much aware that the free reserves were being held to cover events that might not happen.

It was therefore important to have a reliable way of regularly checking the level of free reserves needed.

The club’s internal model gave a considered assessment of the range of outcomes that could occur in the future based on past and current claims experience and market data. Using the model to assess potential one-in-ten events ensured that the club remained aware of the target range for the free reserves.

In the event of big investment gains or a period of very low claims, the free reserves could exceed their target and create a surplus. The model then allowed the club to assess how much of the free reserves could safely be given back to members, for example, by making a return of premium. This was the case in both 2016/17 and 2017/18, with 5% of the total call being returned to members.