Book 2 Reinsurance

Question 1

Describe the considerations that each party would need to take into account in forming a view on an appropriate level of payment under the commutation arrangements

Answer 1

Company A (insurer) wants a large payment, Company B(reinsurer) will wish to pay as little as possible.
Need to estimate total ultimate future recoveries. Start with current best estimate reserves. Analyse claim development patterns but adjust where necessary.

Comment of factors relating to future recoveries on the underlying class (LOB) to be commuted - IBNR depending on length of the tail, outstanding reported claims and how can they be assessed. eg: using case by case estimate for large claims or any other statistical and exposure based analysis. - also consider latent claims - consider different claim types under the class and their claim size distribution.

Other factors which should be allowed for include:  uncertainty of future claims experience  potential for accumulations  the risk appetite of each party  the actual / perceived strength of both parties  the reasons why Company B is seeking the commutation  cost and availability of alternative reinsurance arrangements  the relative strategic / commercial importance of the commutation  effect of the transaction on the accounts of each party  tax position of both parties  negotiating power of each party  profit target for each company  cost of the commutation  expenses saved  treaty terms  adjustments for any profit, including profit commission  allowance for the expected timing of claim payments  expected investment return on reserves  coverage basis  any other reinsurance in place  the discount rate used, if reserves have been discounted  whether the data is out of date  in practice, the payment is likely to slightly favour the party who is receiving the risk, in this case Company A.

Question 2

Explain why an insurer may use a fronting arrangement rather than underwriting a risk directly, commenting on how this may be different for a Lloyd’s syndicate.

Answer 2

Provides immediate access to new markets. An insurer can take advantage of the market position of the fronting insurer. Avoids time, cost and expertise needed to enter a new market organically. There may be tax advantages. It avoids the acquisition costs that would have been payable.
The insurer may not be licensed to write business in a new territory (unlikely for a Lloyd’s syndicate).
An insurer’s credit rating may be inadequate to attract the business directly (although again unlikely).

Question 3

Discuss the approach to outwards reinsurance reserving - (a) Separate projections of gross and net triangles

Answer 3

Reserve for gross losses as normal, then apply the same methodology to the net of reinsurance triangles (both recoveries and premiums).
The reserves for reinsurance will be the difference between gross ultimate claims and net ultimate claims.
For the Bornhuetter-Ferguson approach, we could use the recoveries as a percentage of gross losses as an a priori assumption. Large events may be considered separately.
Advantages:  can be semi-automated  can be used to assess volatility of net outcomes  appropriate for proportional reinsurance / low working layers / very high excess reinsurance
 appropriate where the reinsurance programme has been relatively stable over a number of years  simple to allow for major catastrophes.
Disadvantages:  the past may not be a good guide to the future  less appropriate for non-proportional covers  difficult to allow for interactions between whole account covers, covers specific to an individual line of business and stop loss covers  no direct link between gross estimates and net estimates leading to inconsistent results for capital / ERM team.  does not allow for credit risk  data may not be available at the required level of detail.  difficult to allow for individual features of reinsurance contracts such as aggregate limits, agg retentions and profit commissions  difficult to allow for claims that breach the vertical cover.  possibility of implied negative reinsurance recoveries (net reserves higher than gross)

Question 4

Discuss the approach to outwards reinsurance reserving - (b) Using net/gross ratio

Answer 4

Project ultimate gross losses and multiply by the assumed percentage ceded.
Calculate the percentage ceded using the known cession rate(s) and/or historical experience. The percentage ceded should allow for ceding commission.
Advantages:  appropriate for proportional business  cession rates need only be calculated once, at the start of the year  no need for full triangulations of reinsurance data  gross and net results will be consistent.
Disadvantages:  can be difficult to estimate the ratios to use  requires information on current and historical covers  need data on reinsurance premiums and recoveries split by paid claims / case reserves / cover type / line of business
 difficult to allow for the lower volatility of claims reserves due to reinsurance.  difficult to allow for individual features of reinsurance contracts  difficult to allow for claims that breach the vertical cover.

Question 5

Explain the practice of fronting

Answer 5

Fronting occurs when an insurer, acting as a mere conduit, underwrites a risk and cedes all (or nearly all) of the risk to another insurer which is technically acting as a reinsurer.
Note the fronting insurer remains ultimately liable for the risk if the reinsurer defaults.
Usually the insurer will receive a fee for this from the reinsurer of a certain proportion of the premium.
The business will normally be priced and administered by the reinsurer or one of its associated businesses.
Fronting may also describe the practice where an individual effects a policy for himself but tries to save money by putting the policy in someone else’s name.

Question 6

Describe the possible reasons for insurers to enter into fronting arrangements.

Answer 6

One possible reason for a fronting arrangement is that the reinsurer is not authorised to write the business concerned.
E.g. May not have the product line licensed, and so can only write on reinsurance rather than direct
E.g. May not have relevant licenses for the territory and not want to get licenses / set up subsidiary
It may simply be in another jurisdiction and may not want to set up a subsidiary in the country concerned.
This might be the case for a foreign company wanting to serve its local customers in their overseas operations but this business not being large enough to justify setting up a subsidiary.
Another possibility is where a company has a captive insurance company established in a captive location but local regulations require insurance to be placed locally; this can be particularly the case for compulsory insurances such as employers’ liability and motor third-party liability.
Another possibility is that the reinsurer does not have a sufficiently good credit rating to write the business but there is some particular reason to place the business with it.
The fronting insurer may have a higher rating.
The fronting insurer may have a stronger brand in the market
Another reason for using fronting might be that a company wants to write business that is often sold in a package, but does not want to write the full range of covers in the package; for example, it might want the property element of small-commercial package
business but not the liability element, and it can pass this off in full to a reinsurer.
It may enable the fronting insurer to enter a market without a firm
commitment
The fronting insurer may have stronger administrative and/or distributive capabilities.
There may be tax advantages in this arrangement.
There may be capital advantages in this arrangement.
May be regulatory / conduct / TCF advantages
Low risk fee income
Reciprocal arrangements
May keep a share of it

Question 7

Describe the risks and implications, including advantages and disadvantages, for the insurers concerned in the fronting arrangement.

Answer 7

It is important to note that fronting does not relieve the fronting insurer of the liability to pay the claims under the policies.
If it did then fronting would not achieve the objective of the company seeking a better credit rating than the reinsurer’s.
This means that the fronting insurer has a counterparty risk from the reinsurer: it will remain liable for the claims even if the reinsurer defaults.
This presents a credit counterparty risk, which in a jurisdiction that requires risk-based capital will require a commitment of capital.
May be disadvantage to reinsurer if required to provide LOC or collateral to support this
If the fronting insurer does not handle claims there may also be reputational risk if the originator of the insurer or the reinsurer has problems in its claims handling; there may be other similar reputational risks.
If the fronting insurer runs into financial difficulties then the reinsurer may feel obliged to take over the liability if the nature of the relationship between the reinsurer and the insured’s or the company originating the insurance requires it, for example if the reinsurer is a subsidiary of the originator, which sells the insurance to its customers.
May be excess profits ceded to fronting reinsurer
Fronting is often considered unfavourably by regulators, even if it is not forbidden.
Companies that front in such jurisdictions may harm their relationship with their regulators and may therefore restrict their services in this regard.

Question 8

Describe how a surplus treaty operates

Answer 8

A surplus treaty is a proportional reinsurance, which means that a predetermined proportion of each claim is recovered from the reinsurance.
However, the proportion will vary from policy to policy, the proportion for a particular policy being determined when the policy is written.
For this reason a surplus treaty will normally be written on a risks-attaching basis, covering all policies that are written during the term of the treaty.
The proportion reinsured for a particular policy is at the discretion of the insurer, within the limits set out in the treaty.
The most important determinants of these limits are the retention and the number of lines.
These are normally related to the estimated maximum loss (or probable maximum loss, EML or PML), which is the estimated largest single claim that may occur on the policy, rather than the sum insured.
The EML may be equal to the sum insured under the policy, or it may be less, because the insurer considers that a total loss is not possible, perhaps because of the nature of the insured policy or because the policy covers a number of properties that are
physically separate and at such a distance from each other that an incident affecting more than one is not thought possible.
If a claim arises that is greater than the EML then it still has to be paid by the reinsurer however
The retention is the maximum amount of EML that an insurer may retain without ceding any of the policy to the reinsurer.
It may retain less than this, although there will be a minimum amount that it can retain.
This minimum will be defined by the number of lines on the treaty, although there may be an overriding minimum, known as the minimum retention.
The number of lines is the maximum multiple of the insurer’s selected retention that the reinsurer will accept on a single policy.
This means that the maximum proportion of a policy that the company can cede is L ÷ (L + 1), where L is the number of lines, subject to the minimum retention on the treaty, should there be one.
If the EML on the policy exceeds the treaty retention then the minimum that can be ceded is 1 – R ÷ EML, where R is the retention. Can only cede a maximum of (L+1)*R
After which additional Fac / surplus or retention may be required
If EML > (L + 1) × R then the insurer must cede L × R of the EML,
and the proportion ceded will be L × R ÷ EML.
The actual retention exceeds the treaty retention. In these cases the company must retain more than anticipated in the treaty, or arrange to reinsure the excess, EML – (L + 1) × R, either facultatively or through a second surplus treaty.
The premium paid by the insurer to the reinsurer will be the same proportion as it cedes on each policy, and will be calculated on each of the underlying premiums individually.
Return commission should be paid to the insurer at the same rate as paid on the underlying policies and there may also be an overriding commission, which may be at a fixed rate or depend on the results of the business ceded.

Question 9

Describe the term ‘loss portfolio transfer’

Answer 9

An arrangement whereby the total liabilities in respect of a specified book of business is passed in its entirety from one insurance entity to another.
Policyholders will be informed of this Novation and the deal may need to be approved by a court.
A form of financial reinsurance
Novation is not strictly reinsurance since the new insurer is responsible for the liabilities in total from the date of transfer.
The original insurer will transfer the reserves and the remaining exposure to the new insurer.
It is likely that there will be a premium in addition to the existing reserves.
This would normally include a claims handling service.
All adverse claims risks and the investment income will be passed to the new insurer.

Question 10

Advantages and disadvantages of LPT

Answer 10

Advantages
• They can improve the credit rating of the original insurer.
• A way to exit the business for the original insurer / concentrate on remaining business
• The new insurer will gain diversification if not already in this area and achieve a larger client database.
• Complete transfer of liabilities (both may gain)
• Complete transfer of portfolio risks (mostly gain to former insurer)
• There are specialist players in the market that can possibly run-off such portfolios more profitably than the original insurer.
• Can achieve relatively quick outcome (both may gain)
• Free up capital
• Help in M&A situation
• Could release speciality claims handling resource
• Access to history
• May be a good deal for one or the other party
Disadvantages
• Assets may need to be realised to pass across the value of the reserves to the accepting insurer,
• ..which is particularly important if there is mismatching or if tax
gains/losses would be crystallised.
• If the new insurer defaults, this could damage the reputation of the original insurer.
• Need for court approval may cost in terms of time, resource & certainty
• Uncertainty over approval
• The transfer may require the buy-in of reinsurers where there are existing reinsurance arrangements covering the portfolio.
• There will be an associated cost to the original insurer of the risk transfer, which will depend on the current risk appetite of the market. … This cost would be any premium payable plus the “lost” investment income.

Question 11

List factors influencing the purchase of reinsurance by an insurance company.

Answer 11

Class of business [½]
… likely size, range and volatility of risks [½]
… desire to smooth profits [½]
Size of free reserves [½]
…larger free reserves means less need for reinsurance or higher retentions [½]
Total premiums written [½]
Geographical regions in which the risks are located … [½]
… e.g. geographical concentration [½]
… perils associated with specific regions [½]
Accumulations of risk … [½]
. . . e.g. geographical or other example [½]
… the need for maintaining a balanced portfolio of risks [½]
Current market conditions … [½]
… availability of reinsurance or coinsurance [½]
… perceived value for money of additional reinsurance [½]
… security status of available reinsurers [½]
… regulatory environment [½]
Insurers Preferences … [½]
… risk appetite and tolerance [½]
… underwriter influences [½]
… need for technical assistance [½]
… financial objectives [½]
Expectations of reinsurers … [½]
… interests of cedant and reinsurer aligned [½]
Confidence in the line of business [½]
… especially if new [½]
Capital requirements [½]
Relationships with reinsurance brokers [½]
Expectations of credit rating agencies/regulator

Question 12

Outline possible accumulations of risk that could influence the amount and type of reinsurance an insurance company purchases.

Answer 12

Too much risk written in one particular area… [½]
…reduce large exposures to loss event impacting geographical area. [½]
Too much risk of one particular type has been underwritten… [½]
…for example giving rise to claims arising from same economic event. [½]
…such as a concentration of risk to one industry [½]
…or a concentration of risk to one product subject to a regulatory change [½]
…or a concentration of risk within a particular demographic exposing to pandemic / epidemic [½]
…or a concentration of risk for a particular supply chain [½]
Risks where claims may arise under different classes of business… [½] …such as an explosion that gives rise to losses across marine and property. [½]
Inward reinsurance should be considered alongside direct as possibly common exposures. [½]
Additional marks for other sensible comments (½ each)

Question 13

Outline market conditions that might also influence reinsurance purchasing decisions.

Answer 13

Availability of reinsurance. [½]
Opportunities available to find co-insurers. [½]
Perceived value for money of additional reinsurance… [½]
…modelling may indicate more capital efficient to retain risk [½]
Security status of the available reinsurers. [½]
Regulatory environment… [½]
…in particular any reduction in statutory capital requirements. [½]
Underwriting cycle [½]
Inflation rates and uncertainty [½]
Scope of cover available [½]
Availability of alternatives to reinsurance [½]
Broker relationships impacting cost / placement [½]
Cost of capital [½]
Economic conditions (level of free reserves) [½]
Potential currency considerations [½]
Potential for tax advantages [½]

Question 14

Describe the situations where facultative insurance is used

Answer 14

 risks that are not covered by insurer’s treaty reinsurance  large individual risks  to reduce the size of the EML under surplus reinsurance  as part of reciprocal arrangements  risks that fall outside the reinsurer’s risk appetite  to reinsure coverage provided in addition to standard packages  to reinsure any unusually large line sizes that wouldn’t be economical to cover under standard treaties
 to take advantage of any opportunities that appear cheap relative to direct insurance
 to manage aggregate exposures, eg net line sizes or RDS

Question 15

Differences between insurance and reinsurance business that the student should consider before embarking on a reserving exercise in terms of (a) Reporting delays

Answer 15

Claims reporting delays are longer for the reinsurer [½]
… Claim reporting delays for reinsurers are longer even for proportional reinsurances compared to the delays experienced by insurers. [½]
… reinsurance contracts typically require the insurer to report premiums and losses to reinsurers on a quarterly basis… [½]
…as a result the reinsurer may be notified of its claims under proportional covers up to a quarter of a year later than the insurer is notified. [½]
… In some cases the cedant may be required to provide details only of individual claims above a certain amount. [½]
For excess of loss covers, the claims reporting delays are longer still, as it can take time for the insurer to recognise that a loss is large enough to be reported to the reinsurer… [½]
… particularly if the retention on the excess layer is high. [½]
… As a result of this, casualty reinsurers typically require the insurer to report claims when the incurred claim size exceeds half the excess retention. [½]
For both proportional and non-proportional reinsurance, the reporting process can increase the delays. [½]
… The reporting process can involve the outwards reinsurance team at the insurer, the reinsurance broker, and the claims team at the reinsurer. [½]
… At each stage of this process, additional delays (e.g. adjusting and agreeing the claim) are likely to occur before the information finally reaches the reinsurer’s claims systems.

Question 16

Differences between insurance and reinsurance business that the student should consider before embarking on a reserving exercise in terms of (b) Data and IT System constraints

Answer 16

The information that a reinsurer receives about losses can have less detail than in the information that an insurer receives. [½]
… This is a bigger problem for proportional covers, where the insurer may report losses on an aggregate basis (or provide information only on claims in excess of an agreed amount to the cedant), on the same basis as the contract. [½]
… For example, for a quota share written on a risks attaching basis, the insurer may report aggregate paid and incurred losses to date, associated with risks written in the reinsurance policy period. [½]
If the reinsurer uses an accident year reporting basis for its accounts and regulatory returns, it must somehow split the risks attaching data supplied between accident years. [½]
Usually the insurer provides more information about losses to a non-proportional contract but even then, a reinsurer may need to spend a material amount of time and resource in requesting additional information which it feels that it needs to allocate and treat the losses appropriately. [½]
Where a reinsurance contract covers several lines of business, the loss data may show which losses are associated with which lines. But often the premium is allocated to the line according to a pre-agreed percentage split, perhaps based on the expected split of business when the contract was underwritten. [½]
… To the extent that this split differs from the actual mix of business or does not appropriately allow for different levels of risk between lines of business, the premium split may be inaccurate. [½]
… As premium (adjusted for rate changes) may be the only measure of exposure a reinsurer has, this can lead to a mismatch between exposure and losses in the reserving process. [½]
Because of the complexity and individuality of reinsurance risks, it is difficult for a reinsurer to have IT systems that capture perfectly all the contracts written and their key features. [½]
… It is more difficult than for an insurer, whose contracts tend to be more homogenous. [½]
… This makes storing and accessing accurate information harder for reinsurers. [½]
The actuary working for a reinsurer should be aware of the potential shortcomings of the data that (s)he is using. [½]

Question 17

Differences between insurance and reinsurance business that the student should consider before embarking on a reserving exercise in terms of (c) Additional data and assumption issues

Answer 17

Greater tendency for claims to increase [½]
…greater for non-proportional reinsurance particularly on liability classes due to liability amount disputes [½]
… large claims have longer delays so more time for social and economic inflation to impact final amount [½]
… tendency to underestimate legal costs and other direct claims handling costs for long drawn-out claims [½]
… although reverse can be true for property claims as initial estimates tend to be overcautious. [½]

Greater heterogeneity of exposure [½]
… Reinsurers may write a wide range of lines of business and a wide range of contract types with very different terms and conditions. [½]
… But most reserving methods are based on the assumption that risks are homogeneous; [½]
… and there are large data volumes, so that aggregate results are more stable. [½]

Sparse data [½]
… Particularly for high excess non-proportional business, there may be very few actual claims [½]
so the usual reserving data triangles may be very sparsely populated. [½]
This makes it difficult to determine reliable development patterns resulting in more volatile projections. [½]

Reduced applicability of industry benchmarks [½]
… Because of the heterogeneity of their exposures, different reinsurers can experience very different claims development behaviour. [½]
… This makes industry-wide benchmarks potentially less appropriate, particularly for smaller reinsurers writing business in very specific areas. [½]
… In any event, there are relatively few industry benchmarks for reinsurance claims development, particularly for non-proportional reinsurance. [½]

Data grouping for reserving [½]
… For a reserving exercise, we ideally subdivide loss and premium data into groupings that are as homogenous as possible, and still have enough data in any one group to be able to identify development patterns and so on [½]
… There are a large number of potential groupings: more than for a direct insurer and far more than the volume of data is likely to allow. [½]
… We need to make a compromise between homogeneity and data volumes. [½]
… We may do this by discussing it with underwriters and claims handlers and examining development patterns to find a grouping of categories that are expected to behave in similar fashion.

Question 18

Discuss the reserving methods and approach to carry out the analysis for the non proportional property treaty:

Answer 18

Typically all types of property treaty business (facultative or excess, catastrophe or per risk) considered to be shorter tailed… [½]
other than high excess property treaty (which might be treated more like casualty treaty) [½]
Use relatively straightforward reserving approaches, such as chain ladder [½]
… or expected loss ratio, using rate and inflation-adjusted historic loss ratios as a guide. [½]
The effort required for more complicated methods is unlikely to be rewarded with a materially different or more accurate end result. [½]
We may spend time and resources more productively in improving the analysis for other parts of the reinsurer’s inwards business. [½]
The chain ladder approach may have the added benefit of being easier to extend to a stochastic approach to produce a distribution [½]
We should be careful with major catastrophe losses, particularly recent catastrophes. [½]
It may be best to exclude all major catastrophes from the main methodology, reserve for them separately and then add them back at the end of the process. [½]
We could use historical experience from other similar types of catastrophe as a guide to the likely future development of more recent events… [½]
… for example, US windstorms, US earthquakes, European windstorms, European floods etc. [½]
May review the development in finer detail for catastrophes, for example, looking at monthly or weekly development, rather than annual, to allow better for the time of year that the event occurred.

Question 19

Discuss the reserving methods and approach to carry out the analysis for the non proportional casualty treaty:

Answer 19

Typically all types of casualty treaty business treated as long-tailed reinsurance business (proportional casualty treaty, casualty excess treaty, casualty aggregate excess, casualty facultative) [½]
Commonly use chain ladder based methods… [½]
… usually in conjunction with the Bornhuetter-Ferguson, or Cape Cod approaches, [½]
… with separate treatment of major catastrophes. [½]
There could be reserving problems for new or recently established reinsurers, where the oldest development year is not yet mature… [½]
… a tail may need to be estimated based on analysis of case estimates and projected number of future claims [½]
… or a suitable benchmark if available [½]
Legislative / legal changes should be considered [½]

Incurred vs Paid Data
Incurred losses are the result of an aggregation of loss data from a number of different insurers [½]
… with slightly different reserving practices [½]
… which may have changed in the past. [½]
… and a reinsurer’s pool of cedant insurers may change from year to year [½]
… so the incurred data for a reinsurer will be much less consistent than for a direct insurer. [½]
… the reinsurer’s claims team would have to review all the losses submitted and adjust the data submitted to make the year-by-year and cedant-by-cedant data more consistent. [½]
… as a result, it is appropriate for a reinsurer to rely more on paid development-based reserves than incurred [½]
… because the payments depend less on individual insurers and more on legal process. [½]

Expected Loss Ratios
We may be able to use the target loss ratios from the pricing of the contracts. [½]
If we do not use these directly, we may combine the pricing loss ratios (perhaps using a credibility weighting) with inflated and rate-adjusted historic loss ratios, say, as an input into the process.

Question 20

Describe catastrophe bonds, commenting on how they work in practice

Answer 20

 A way of tapping into the capital markets for reinsurance coverage instead of traditional reinsurance [½]
 These Cat bonds allow (re)insurers to transfer high severity low probability catastrophic risks to the capital market [½]
 …and spread them among many investors, who all buy only small proportion of the risk [½]
 A Special Purpose Vehicle is usually created to hold the premium and the investment. [½]
 The investment usually earns interest, which is passed on to the Bondholders [½]
 if the specified catastrophic risk is triggered, the bondholders typically forfeit the interest and principal on the bond to the (re)insurer [1]
 The claim payout is usually determined based on a pre-agreed criteria, often linked to some form of an ‘index’
For example, category of the hurricane, or magnitude in the case of earthquakes, rather than on its own losses [½]
 The payout will then be used to pay claims [½]
 If there is no catastrophic event, or trigger event before the maturity date of the contract, investors receive their principal investment at maturity on top of the interest payment they have received. [1]

Question 21

Discuss the advantages and disadvantages associated with the use of catastrophe bonds.

Answer 21

Advantages
 Better pricing may be available than on reinsurance markets when the reinsurance market is hard [½]
 Increased capacity - sometimes traditional reinsurance may not be having an appetite for certain risks [½]
 Objective criteria when paying out the loss amounts and less ambiguity [½]
 Collateralized protection through the use of Special Purpose Vehicle, traditional reinsurers more likely to default [½]
 Usually written for multiple years, locking down the premiums [½]
 Source of diversification for the cedants [½]
 From the view point of buyers of Cat bonds, it provides them with a completely diversified source of risk and return since cat losses aren’t correlated with investment markets [½]

Disadvantages
 As with normal reinsurance, profits are ceded in good years [½]
 Might not always be available [½]
 Pricing can be quite volatile depending upon the recent events [½]
 Insurer may lack knowledge to adequately price [½]
 Terms and Conditions can be stricter since capital market investors are not very well versed with Insurance [½]
 In case a catastrophe does occur, it can be quite disastrous from the investor’s perspective, and can dry up the liquidity in the cat bond market in the subsequent periods [½]
 Administrative work will be higher compared to the traditional reinsurance, since capital markets are involved. More disclosures may be required and there could be data privacy issues if the data has to be shared with the clients to prove validity of claims [½]
 Ordinarily, there won’t be a reinstatement [½]
 Can be more difficult insurers to model in their capital models and reserves [½]
 Accounting process may also be more complicated [½]

Question 22

Define facultative reinsurance and state advantages and disadvantages

Answer 22

Facultative reinsurance is reinsurance of a single risk. [½]
Reinsurance is required is offered separately on each individual risk. [½]
There is no obligation for the ceding company to offer the business [½]
…nor is the reinsurer obliged to accept the quote. [½]
Each case is considered on its own merits [½]
…and the reinsurer is free to quote whatever terms and conditions it sees fit to impose for
that risk. [½]
Commonly used for very large risks or portions of risk written by a single insurance [½]

Advantages:

• Flexibility for insurer [½]
• Flexibility for reinsurer [½]
• Insurer can write risks that are bigger than its own appetite [½]
• Can insure risks that may be outside the scope of its treaty reinsurance programmes for some reason [½]

Disadvantages:
- It is a time-consuming [½]
- …and costly exercise to place such risks. [½]
- There is no certainty that the required cover will be available when needed. [½]
- Even if cover is available, the price and terms may be unacceptable. [½]
- The primary insurer may be unable to accept a large risk until it has been able to find the required reinsurance cover [½]
…this means the insurer cannot accept business automatically when it is offered, and
consequently its standing in the market may be reduced. [½]

Question 23

Describe financial reinsurance and its features

Answer 23

The aim of financial reinsurance tends to be risk financing rather than traditional risk transfer. This is typically a multi-year contract aimed at reducing the cedant’s cost of capital by means of earnings smoothing. The contract reduces year-to-year earnings volatility but it provides limited risk transfer over the whole contract period.
A wide variety of financial reinsurance contracts exist, although all have been devised primarily as a means of improving the apparent accounting position of the cedant.

The main feature of a financial reinsurance contract is that it involves only a small element, if any, of transfer of insurance risk from the cedant to the reinsurer. The contract, however, does involve investment type risks. Many forms of financial reinsurance are, in fact, often viewed as being more similar to investment than to reinsurance. Usually the effective ‘return’ that the contracts provide is low in comparison to conventional investments.
Typical features might be: 
limited assumption of risk by the reinsurer
 multi-year contract term  explicit inclusion of investment income in the contract  sharing of the results with the cedant  risk transfer & risk financing are combined, for example time and distance deals.

Question 24

Describe time and distance deals

Answer 24

An insurer pays a single premium in return for a fixed schedule of future payments matched to the estimated dates and amounts of the insurer’s claim outgo. The purpose of such contracts was to achieve the effect of discounting in arriving at the reserves for outstanding claims.
They were useful in the past to insurers who were not permitted to discount their reserves (eg Lloyd’s syndicates).
Since Lloyd’s changed its rules so that the credit allowed for time and distance policies in a syndicate’s accounts was limited to the present value, such policies have become less popular.
A financial reinsurance contract has to have a reasonable level of risk transfer if it is to be treated as reinsurance under most systems of accounting principles; otherwise it is treated as an investment and may thus lose its appeal.

Question 25

Describe spread loss covers

Answer 25

Spread loss covers involve the insurer paying annual or single premiums to the reinsurer for coverage of specified claims. These accumulate with interest (contractually agreed) in an experience account, the balance of which is settled at the end of the multi-year period.
These types of contracts involve very limited underwriting risk (limited practical risk transfer) but provide the insurer with the liquidity and security of the reinsurer.

Question 26

Describe industry loss warranties

Answer 26

Industry loss warranties (ILWs) are a type of reinsurance contract where the basis of cover is not indemnity, ie repayment of actual losses suffered.
Here one party will purchase protection based on the total loss arising from an event to the entire insurance industry rather than their own losses.
The original size of the industry loss is used as a trigger for a recovery.
Given the recoveries on these losses have limited relationship to the actual losses incurred by the insurer, the treatment of potential recoveries for accounting and solvency purposes differs to that of reinsurance.
Note that the name Original Loss Warranty (OLW) is sometimes used for the same concept.

Question 27

Describe run off reinsurance

Answer 27

The aim of run-off reinsurance is the transfer of reserve development risks. It provides cover against the insurer’s earnings volatility arising from past activities. It may be sought in circumstances such as:  corporate restructuring  mergers and acquisitions 
closing lines of business
 economic changes in the value of the liability 
regulatory, accounting or tax changes  legal developments, for example court decisions.
The ‘book’ is sold to the reinsurer who assumes all remaining premiums and all of the risk. The claims reserves are also transferred from the insurer to the reinsurer.
There are two main types of run-off reinsurance:  adverse development cover  loss portfolio transfers.

Question 28

Describe adverse development cover

Answer 28

ADC is a reinsurance arrangement whereby a reinsurer agrees, in return for a premium, to cover the ultimate settled amount of a specified block of business above a certain pre-agreed amount.
The premium that is payable for the cover will depend on the risk appetite of the market.
Usually it is only possible to reinsure a layer above a specified amount. This specified amount may be in excess of the current level of reserves. There could be an upper limit. If the ultimate cost of losses is in excess of this, the insurer is liable for the excess. The reinsurer may also insist that the insurer has a small participation in the layer, to retain a commercial interest in keeping claims costs down.
These contracts can be structured to cover the current reserves plus a pre-defined amount of claims deterioration, although these tend to be much more expensive than typical ADC.
When structured in this format, it is sometimes referred to as loss portfolio transfer (LPT) reinsurance and the insurer will usually need to retain a small participation in the covered reserves. This differs to a true LPT which is described below.
Claims are usually still handled by the insurer and hence there are the associated expenses. Reserves are maintained by the insurer and it receives all investment income generated from the investments backing these reserves.
The insurer is exposed to the credit risk of the reinsurer. Legally, the insurer remains liable to the insured parties for all claims within the block reinsured. Hence, some but not all of the risk from adverse run-off of the reserves is removed.

Question 29

Describe insurance linked securities and its pros to the buyers and sellers.

Answer 29

Insurance-linked securities (ILS) are an innovative way of increasing (re)insurance capacity. The valuation and performance of these financial instruments are driven by the occurrence (or lack of occurrence) of insurance loss events.

ILS offer acquirers (such as institutional investors and pension funds) an opportunity to invest in instruments, the returns from which are largely uncorrelated with other financial assets and macroeconomic movements and allow them to exclude surrounding risks (such as the market risk in share prices) of investing in reinsurance companies. For purchasers, who are typically insurers or reinsurers, ILS provide an additional source of protection and insurance risk mitigation instruments.

Question 30

List some quantitative tests to assess the performance of a reinsurance program - Part 1 - Mean loss ratios

Answer 30

1. Mean loss ratio - The mean loss ratio for the reinsurer is based on underlying modelling assumptions (whether pricing assumptions or capital model parameters). When calculating this, consideration should be given to the treatment of reinstatements. These can be added to the reinsurance premium used as the denominator, which is aligned to the accounting treatment if a loss did occur. Alternatively, they can be allowed for as a deduction to the likely level of recoveries to be received, which may be of more value if assessing the level of profit to be ceded on an initial upfront reinsurance spend. Modelled impacts on net or final net loss ratios can also be considered

Question 31

List some quantitative tests to assess the performance of a reinsurance program - Part 2 - Capital Impact

Answer 31

The amount of capital saved as a result of the reinsurance programme being purchased is a useful metric to consider, as this is both a practical indication of the amount of capital saved and an indicator of the extent of mitigation provided to the overall risk profile.

Question 32

What are the three approaches to measure capital impact

Answer 32

1. Marginal capital impact of adding or removing a particular programme. We will have to carry out two capital model runs - one with and one without the program being considered and compare the 2 outputs. - there is a risk of overstating the capital significance of the program and also very cumbersome as it requires series of separate runs for each program being tested.
2. Consider the contribution of recoveries from different programmes to simulations around the target return period (eg 1 in 200), and to use this as a way of allocating the overall capital benefit of reinsurance (which can be calculated by running the capital model with all reinsurance cover removed).
3. Consider a lifestyle capital view - The capital benefit of a catastrophe programme for example, might be significant to current capital requirements but the continuing benefit of that same programme to future years’ capital requirements may be limited once the business has earned. Conversely, capital benefits from a quota share of a long-tailed portfolio may be low in any individual year but might continue to provide benefits over multiple years as the underlying exposures remain volatile for a number of years.

Question 33

List some quantitative tests to assess the performance of a reinsurance program - Part 3 - Ceded return on equity

Answer 33

Expected profit ceded divided by modelled capital saved (whichever method is used) provides a useful single metric for the effectiveness of a reinsurance programme.
This produces a return on capital metric that can then be compared against other return on capital measures used for other decision making; although it should be noted a lower value is preferable, ie better reinsurance programmes do not need to cede away as much profit to achieve the same reduction in capital.
For example, if a reinsurance programme is expected to cede away $100,000 of profit for a $1m reduction in capital then it would have a 10% ceded return on equity. If there are alternative opportunities available at 8% return on capital, then the $1m of capital saved in theory can only be deployed to generate $80,000 of profit so the programme would reduce the overall profit achievable. It may however, still be appropriate to place if it achieves risk mitigation or other objectives.

Question 34

List some quantitative tests to assess the performance of a reinsurance program - Part 4 - Return periods

Answer 34

It can be valuable to assess the likelihood of certain outcomes with different reinsurance programmes, eg the return periods at which:
1. the reinsurance programme begins to be utilized
2. individual losses go above the upper limit of the programme
3. the reinsurance programme and associated reinstatements are exhausted leaving no cover remaining
4. any parametric triggers (eg for an Industry Loss Warranty) are reached.
It may also be useful to assess the modelled outcomes of the overall loss distribution or components of a loss distribution at various return periods, either to align to regulatory reporting requirements or to internal risk appetites. An example might be managing the 1 in 30 modelled aggregated catastrophe losses for Lloyd’s reporting.

Question 35

List some quantitative tests to assess the performance of a reinsurance program - Part 5 - Historical As if performance

Answer 35

Programmes can also be tested against internal historical experience, by assessing the recoveries and reinstatements that would have been incurred if the programme had been in place historically. This provides an alternative to a modelled loss ratio view, although credibility is dependent on data volumes which may be limited for many organisations, particularly for higher layers.
Consideration should be given to the need for any adjustments to historical losses, eg indexation for claims inflation or adjustments for exposure levels.

Question 36

Outline how reinsurance can reduce capital requirements.

Answer 36

An insurer may wish to purchase (additional) reinsurance to reduce its regulatory capital requirements.
Regulators will require insurers, on writing a book of business, to allocate capital against this business to cover future losses.
Through an effective reinsurance strategy, we reduce the amount of capital required to support this book because the insurer is transferring exposure to the risk of losses to the reinsurer.
Following the previous point that reinsurance can be used to reduce the amount of capital required, we can consider it to be a form of capital. By purchasing an effective reinsurance programme, an insurer can free up capital that is otherwise allocated to support the premium income against future uncertain losses. Therefore, reinsurance can be an effective means of reducing the capital required and may be cheaper than raising extra capital by other means. The insurer could use the extra capital to generate increased revenue by writing additional business.

Question 37

Explain what inwards reinstatement premiums are and outline the various considerations when estimating them.

Answer 37

Inwards reinstatement premiums are the premiums for the restoration of the reinsurance cover to its full amount after a loss occurrence by the cedant. These are premiums payable to the reinsurer so are a cash inflow component of the reinsurer’s technical provisions and should be recorded and tracked separately. From an estimation perspective, they can be calculated explicitly at a policy level in relation to specific claims which trigger reinstatement premiums or at an aggregate level using chain ladder-based methods.
The circumstances under which reinstatement premiums are payable are specific to individual contracts and vary with contract terms, making aggregate methods more difficult to apply and may make actuarial projections unreliable if terms for reinstating reinsurance have changed over time (eg an increase in free reinstatements in a soft market), or comparisons to historical years cannot be made (eg catastrophe years compared to non-catastrophe years).
As with all premium estimation in early development, involvement of underwriters will be important to assess the income for individual portfolios. In particular, where reinstatement of coverage is in relation to catastrophe coverage post-event, underwriters will be involved in providing estimates of both the claims cost payable as well as any additional reinstatement premium receivable.

Question 38

List the approaches for reserving for outwards reinsurance

Answer 38

1. Reserving using data gross and net of reinsurance
2. Applying standard reserving techniques to reinsurance premium and claims
   data triangles
3. Applying broad brush factors to projected gross data
4. Case by case reserving
5. Developing individual losses and applying the reinsurance programmes to
   them
6. Net distributions - a. Derive a gross distribution, and scale down the distribution such that the mean
   equals the net best estimate.
   b. Estimate a distribution of reinsurance to gross reserve ratios and apply this to the gross reserve distribution.
   c. Use a net triangle rather than a gross triangle to derive the predicted distribution.
   d. Simulate individual claims and net down explicitly before aggregation.

Question 39

Market conditions that may influence reinsurance purchase

Answer 39

the availability of reinsurance
opportunities available to find coinsurers
the perceived value for money of additional reinsurance
the credit rating of available reinsurers
the regulatory environment …
… especially the extent to which solvency requirements reflect reinsurance purchased.
the underwriting cycle
availability of alternatives to reinsurance, eg ART products
claims inflation levels and variability, eg this could affect the excess points chosen (if there’s no stability clause)
the breadth of cover available
the desire to maintain relationships with existing reinsurance brokers
investment conditions, as these affect the level of free assets
potential currency considerations
the cost of capital
potential tax advantages.