Lancashire has a comprehensive Enterprise Risk Management (“ERM”) program. The Board sets the overall Group risk profile and appetite and is responsible for monitoring risk at Group level. Day-to-day ERM activities are coordinated by Lancashire’s Chief Risk Officer (“CRO”).
Risk Committees have been formed at the operating entity level. Each Risk Committee operates under terms of reference that details its scope and operation. The Risk Committees define tolerance levels over categories of risk for the operating entities. This includes the level of capital the operating entities are willing to expose to certain risks.
The management of various types of risks is described in more detail below.
BLAST
Lancashire has developed a sophisticated economic capital model called BLAST, which is an integral part of Lancashire’s ERM program. BLAST provides management with information on risk and return that can assist with business decisions.
It is primarily a stochastic model, which encompasses insurance risk, market risk, credit risk and other general risks including operational risk and requires the input of a large number of parameters and data.
BLAST helps determine the level of capital required across the Group to meet the combined risk from a wide range of categories. BLAST is a useful tool, the results of which are incorporated into the day-to-day decision making and assists management in monitoring its risk adjusted returns.
Insurance risk
Lancashire underwrites contracts that transfer insurance risk. Lancashire underwrites worldwide short-tail insurance and reinsurance risks, including risks exposed to natural and manmade catastrophes. Lancashire’s exposure in connection with insurance contracts is, in the event of insured losses, whether premium will be sufficient to cover the loss payments and expenses. Insurance and reinsurance markets are cyclical and premium rates, and terms and conditions vary by line of business depending on market conditions and the stage of the cycle. Market conditions are impacted by capacity and recent loss events, among other factors.
Lancashire’s underwriters assess likely losses using their experience and knowledge of past loss experience as well as current circumstances. This allows them to estimate the premium sufficient to meet likely losses and expenses. Lancashire considers insurance risk at an individual contract level, sector level, geographic level and at an aggregate portfolio level to ensure careful risk selection, limits on concentration and appropriate portfolio diversification are accomplished. Natural catastrophe exposed risks are modeled prior to execution.
Reinsurance
Lancashire, in the normal course of business and in accordance with its risk management practices, seeks to reduce certain types of loss that may arise from events that could cause unfavourable underwriting results by entering into reinsurance arrangements. Reinsurance does not relieve Lancashire of its obligations to policyholders.
Under Lancashire’s reinsurance security policy, the Reinsurance Security Committee assesses reinsurers as appropriate security based on their financial strength, ratings and other factors. Lancashire monitors the credit-worthiness of its reinsurers on an ongoing basis.
Lancashire regularly reviews its exposure to natural and man-made catastrophic events and under the right set of circumstances will purchase reinsurance in order to reduce its exposure to a catastrophic event.
Market risk
Investment guidelines are established by the Investment Committee of the Board to set parameters within which Lancashire’s external investment managers must operate and compliance with these guidelines is monitored on a monthly basis. Important parameters include guidelines on permissible assets, duration ranges, credit quality and maturity.
Lancashire reviews the composition, duration and asset allocation of its investment portfolio on a regular basis
in order to respond to changes in interest rates and other market conditions. If certain asset classes are anticipated to produce a higher return within the Group’s risk tolerance, an adjustment in asset allocation may be made.
Lancashire is also subject to market risk on its insurance portfolio.
The most important measure to mitigate insurance market risk is to maintain strict underwriting standards. Examples of how Lancashire reacts to insurance market risk include the following:
- Review and produce underwriting plans and budgets as necessary;
- Reduce exposure to market sectors where conditions have softened;
- Purchase appropriate reinsurance cover to mitigate increased exposures;
- Closely monitor movements in rates, and terms and conditions; and
- Regular review of output from Lancashire’s economic capital model, BLAST, to judge up-to-date profitability of classes and sectors.
Liquidity risk
Lancashire is exposed if proceeds from financial assets are not sufficient to fund obligations arising from its insurance contracts. Lancashire can be exposed to daily calls on its available investment assets, principally from insurance claims. Liquidity risk is the risk that cash may not be available to pay obligations when they are due without incurring an unreasonable cost.
Lancashire manages its liquidity risks via its investment strategy to hold high quality, highly liquid securities, sufficient to meet its insurance liabilities. The creation of the core portfolio with its sub-set of guidelines ensures funds are readily available to meet potential insurance liabilities in an extreme event plus other near term liquidity requirements.
In addition, the Board has established asset allocation and maturity parameters within the investment guidelines such that the intention is to have the majority of Lancashire’s investments in high quality assets, which could be converted into cash promptly and at minimal expense. The Group monitors market changes and outlooks and re-allocates assets as deemed necessary.
Credit risk
Credit risk is the risk that a counterparty may fail to pay, or repay, a debt or obligation. Lancashire is exposed to credit risk on its fixed income investment portfolio and derivative instruments, its inwards premium receivable from insureds and cedants, and on any amounts recoverable from reinsurers.
Credit risk on the fixed income portfolio is mitigated through Lancashire’s policy to invest in instruments of high credit quality issuers and to limit the amounts of credit exposure with respect to particular ratings categories and any one issuer. Lancashire aims to limit its exposure to any significant credit concentration risk on its investment portfolio.
Lancashire is exposed to credit risk in the event of non-performance of counter-parties to derivative contracts. These instruments are typically net settled and are short-term in nature.
Credit risk on inwards premium receivable from insureds and cedants is managed by conducting business with reputable broking organisations with established relationships and by rigorous cash collection procedures. Credit risk from reinsurance recoverables is primarily managed by review and approval of reinsurer security by Lancashire’s Reinsurance Security Committee.
Lancashire also periodically monitors the creditworthiness of brokers pursuant to its broker vetting procedures.
Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people or systems including the risk of fraud, safety, damage to physical assets, business disruption, system failure and transaction processing failure.
Lancashire has a robust internal corporate governance framework. Policies and procedures are documented and are reviewed periodically. Lancashire’s internal audit function assesses the key risk areas on an annual basis and performs periodic reviews of these areas to evaluate whether controls are in place and are operating effectively.
Information technology risk tolerances have been identified and system performance is monitored continuously. Lancashire’s disaster recovery plan is assessed and updated on a periodic basis.
Lancashire’s operations are regulated in each of the jurisdictions it does business. Changes in local regulatory frameworks or taxation regulations could impact the way the local entities and/or the Group conducts business. Therefore, Lancashire regularly monitors for changes in law and regulation that could impact its business.
Lancashire is in a mature trading position having had over three years to develop broker and client relationships and has established an enviable market reputation. Lancashire is vulnerable to adverse market perception since it operates in an industry where customer integrity, trust and confidence are paramount. In addition, any negative publicity (whether well founded or not) associated with the business or operations of the Group could result in a loss of clients and/or business. Lancashire therefore actively assesses its relationships with brokers to identify strengths and also assesses for improvements.
Strategic risk
Strategic risk encompasses the risk that poor business planning and vision may produce a lower return on capital and value creation. Further, this could lead to risk tolerances being unclear or inappropriate. The Group addresses this risk by a continual rigorous assessment of business goals. The BLAST model is increasingly an integral part of the review of profitability and capital utilisation. Lancashire’s Board has established a rolling three-year strategy that is reviewed at least annually. Business performance within the context of the overall strategy is reviewed with the Board on a quarterly basis. Market or economicevents may lead to a need to re-assess strategy more frequently.
Further details
Further discussion of the risks affecting Lancashire and the policies in place to mitigate those risks can be found in the risk disclosures section of the financial statements.