Capital Tranching: A RAROC Approach to Assessing Reinsurance Cost Effectiveness

The current industry standard approach evaluates reinsurance effectiveness by calculating capital cost savings as the product of a fixed capital cost rate and the required capital which is released. Reinsurance is deemed value-creating if the resulting capital cost savings is more than the profit margin ceded to support the purchase—a Return On Risk-Adjusted Capital (RORAC) approach. In reality, however, insurers do not typically release capital as a result of a reinsurance purchase. Rather, capital is generally fixed for the planning cycle. Capital cannot be simultaneously fixed and risk-adjusted. Instead of a RORAC measure, a Risk-Adjusted Return On Capital (RAROC) can be calculated using fixed capital. This requires a means of calculating the risk-adjusted return as a function of the capital consumed. One such calculation can be done by replacing the capital with its reinsurance equivalent: a set of earnings stop-loss reinsurance covers, or what can be called Tranched Capital. Examples will show how Tranched Capital and RAROC can produce very different indicated reinsurance purchases than does the ISA. The RAROC approach is more consistent with realistic insurer capital management, and provides different interpretations of the cost-benefit tradeoffs of reinsurance.