30 Reinsurance Flashcards
The reasons for reinsuring
- Increase in capital
- Insurers require capital to hold risks
- by transfering risks to a reinsurer, the capital requirement can be reduced
- Limit the amount paid on any particular claim
- Limit total claims payout. (Through stop loss or catastrophe exess of loss)
- Reduce insurance parameter risk.
- quota share reinsurance would be used to share the parameter risk with the reinsurer.
- share the risk that level of claims are different from expected
- Although in practice the reinsurer would review the premium rates and the insurer’s control
- Reduce claim payout fluctuations
- Variance can be high due to:
- small number of contract for very large lavel of cover (Coinsurance/riskpremium method - individual surplus basis)
- lives insured are not independent risks (catastrophe, stop loss or excess of loss)
- Receive technical assistance
- considerable degree of expertise in underwriting, product design, pricing and systems design
- particularly important when a cedant intends to launch on a new line of business
- can give support for existing lines in areas such as underwriting
- Reduce new business strain
- through increase in capital (financial reinsurance)
- or through reduction in financing requirement (Original term - QS)
- Increasing available capital, will allow the insurer to write more new business, before NBS leads to tooo low solvency position
- Reducing new business strain means that more new business can be written for the same amount of capital
- reducing the extent of its parameter risk
- original terms reinsurance (with a high quota share reinsured) would be the most likely reinsurance to be used
- high quota shares will generally be reduced over time, as the insurer’s experience and expertise develops
- Reduce overall capital requirements by using a reinsurer’s capital
- Reinsurers may have lower capital requirements due to risk diversification
- Separate out different risks from a product
- allowing the cedant to optimise its risk management and capital requirements
- Allow aggregation of risks the cedant cannot manage on its own
- Cost reduction
- Due to different capital requirements, diversification benefits, different taxation and different assessment of risks
- reinsurer may be able to price the risk at a lower cost than the cedant
- may be able to pass on some of those profits by offering more favourable terms for its reinsurance
Considerations before reinsuring
Cost
- reinsurer intends to make a profit as well as meet its cost of capital and expenses
- costs will reduce the expected absolute level of profit for the cedant
- must balance the increased cost of reinsurance against the increased risk of loss from adverse experience if less reinsurance were to be used
- setting up a mortality fluctuations reserve requires capital
- However, risk reduction caused by reinsurance may leverage up the return or risk-adjusted return on capital
Considerations before reinsuring
Retention limits
factors to take into account when setting the retention limit include
Factors to consider: (UP Over FABRIC)
1. How familiar the company is with underwriting the type of business
2. Existence of profit-sharing arrangement in reinsurance treaty
3. Other product’s retention limit
4. Free assets level and importance of free asset ratio stability
5. Available reinsurance terms and dependence of such terms on retention limit
6. Average benefit level for the product and the expected distribution of the benefit
7. Risk appetite of the insurer (the smaller the company, the smaller the RL)
8. Nature of any future increases in sum assured
9. Effect of increasing or decreasing retention limit on regulatory capital requirements
Considerations before reinsuring
Counterparty risk
- cedant retains liability to the policyholder for the benefits even if the reinsurer becomes insolvent
- The amount of exposure to the reinsurer is known as credit risk.
- Reduce counterparty risk by reinsuring with different reinsurers through diversification
- Deposits back
- May be a supervisory requirement
- require the reinsurer to collateralise or “deposit back” its share of the total reserve under a reinsured contract with the cedant
- the reinsurer simply has to make up (the reinsured share of) the shortfall between the reserve and the sum assured on a death claim
- cedant gets the benefit of reinsurance
- while being able to maintain a reserve for the whole contract and hence maximise the funds it has to invest
Considerations before reinsuring
Legal risk
- reinsurance is usually governed by a treaty between the ceding company and the reinsurer
- many clauses to be negotiated to cover numerous contingencies and risks
- each one potentially impacting the price of the reinsurance
- Due to the operational risks involved and the impact of disputes where contracts have not been finalised, regulators around the world are increasingly focused on ensuring that reinsurance treaties are complete and signed.
Considerations before reinsuring
Type of reinsurance
Type and amount reinsured will depend on:
1. The reason the ceding company is using reinsurance
2. The reinsurance costs
3. The type of business (term, with-profit, annuity, group business, unit-linked)
4. The legal conditions applying
5. The forms of reinsurance coverage actually on offer in the market
Determining Retention limits
(1) Stochastic simulation – reinsurance only
Set the retention limit at such a level as to keep the probability of insolvency (or ruin probability) below a specified level
- stochastic model
- projecting claim rates and value of assets and liabilities
- retention level can then be determined such that the company stays solvent, or earnings stay above a certain level, for 995, say, out of 1,000 runs
- most important variable: Mortality rates, and its random fluctuations variance, and the mean mortality rate
- the greater the overall variance assumed, the more reinsurance will be indicated by the model for a given probability of ruin
- key element of the model points is the distribution of the sums assured
Determining retention limits
(2) Stochastic simulation – reinsurance with fluctuations reserve
Consider the total of:
(a) the cost of financing an appropriate mortality fluctuation reserve; and
(b) the cost of obtaining reinsurance
As the retention limit increases:
(a) will increase and
(b) will decrease.
A retention limit can then be adopted which minimises the total (a) + (b).
To calculate (a), the simulation approach need to be used to determine the reserve the company needs to hold.
The process:
1. Decide on some criterion for claim volatility beyond which the company cannot go.
2. For differing retention limits, model the function X=“{total claims net of reinsurance} - {total risk premiums net of reinsured risk premiums}”
3. This modelling will be done stochastically, varying the mortality experience.
4. The criterion would therefore be that Pr( X > 25m ) = 0.01
5. Look at the results of this modelling to choose the retention limit that will satisfy your criterion
6. We could use this as a retention limit
7. However, we could also check if this protection can be done more cheaply using a mortality fluctuation reserve
8. To do this we might assume that some of the cost of the risk premium reinsurance is instead going to be spent on financing a mortality fluctuation reserve.
9. The cost of holding a reserve of size M is equal to = M(j-i)
10. j is the expected rate of return from the company’s capital
11. i is the expected rate of return from the assets that will back the reserve
12. Now model X= Net claims - Net premium - M
13. Recalculate P( X > 25m )
14. If this probability is less than the 1% previously obtained, then using a mortality fluctuation reserve (to the extent assumed) is cheaper than using reinsurance, and would therefore be the preferred strategy.
15. Try this for other levels of reinsurance / mortality fluctuation reserve.
16. decide on which combination offers the most protection for a given cost.
Determining retention limits
(3) Financial economics approach
- based on the theory of efficient investment frontiers
- looks at reinsurance as an asset class that allows the firm to optimise its risk and reward trade off.
- This approach allows you to identify those “asset” portfolios (including reinsurance), which cannot be bettered in terms of either reducing risk for no reduction in return, or increasing return for no increase in risk
Examples
A new unit-linked company with limited capital resources
Needs:
- Low retention (to reduce mortality ot morbidity risk while portgolio is small)
- reduce new business strain (to grow faster)
Types:
(1) Risk premium reinsurance (QS or low retention individual surplus)
The company will probably wish to build up its retained premium income as quickly as possible
Effective, since only SAR (death benefit - unit fund) needs to be reinsured
Unit-linked: usually not original terms, since reinsurer would have to match the cedant’s unit fund
(2) FInancing commission arrangement
to help reduce the new business strain, if such an arrangement effectively reduces capital requirements under local regulations
(3) catastrophe reinsurance
Examples
A large established mutual life insurance company mainly transacting with-profits business
Needs:
- Large = probably healthy free assets = can absorb high level or mortality risk & finance new business from own resources
- With profit = can reduce bonuses to reflect mortality losses
(1) risk premium reinsurance
No commission & large retention limit = large free assets
If it offers guaranteed death benefits in excess of asset share and does not wish to reduce bonuses in the event of a significant increase in mortality experience
(2) Catastrophe cover
Examples
A large proprietary company which is expanding rapidly and whose free assets are declining
Needs:
Expanding rapidly: new business strain
free assets declining: want to reduce financing requirement
Proprietary: scrutiny from the stock market on measures such as return on capital employed
(1) Financial reinsurance
(2) risk premium reinsurance with financing commission
with the retention set such that the company obtains the required reduction in new business strain,
but without giving away too much profit to the reinsurer
(3) Catastrophe cover
since free assets are reducing
(4) Stop loss or assumption swaps
to reduce the capital employed, creating leverage, and so increasing the firm’s own return on capital.
Examples
A company writing large amounts of group life insurance business
Needs:
Group = concentration risk = major risk is adverse fluctuations in mortality experience and catastrophe risk
Large = high retention
(1) catastrophe cover
(2) Risk premium reinsurance
High retention
indivudal surplus
OR quota share
